Arbitrageur
Lastly comes the ‘Arbitrageur.’
An arbitrageur is a type of individual who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.
An arbitrageur would, for example, look for price differences between stocks listed on more than one exchange, and then buy the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.
Arbitrageurs also play a very pivotal role in the operation of capital markets. They are also known as market makers as their efforts in exploiting price inefficiencies keep prices more accurate than they otherwise would be.
Arbitraging Through Futures
Arbitraging in the equity market or any other market could be possible by using various types of derivatives products. Arbitraging via use of futures contracts is one of the most widely used methodologies of arbitrage in the Indian markets.
Even though over the last couple of years the systems have taken over a lot of roles from human individuals in the job market for arbitrageurs, still individuals with good quantitative skills and bent for adoption to technology have fared quite well and their requirement would always exist.
- If Future is overpriced: Buy spot, sell futures
- If Futures is under-priced: Sell Spot, Buy futures
Future is overpriced: Buy spot, Sell futures
Say, a stock, ABC Ltd. trades at ₹1000 in the cash market or spot market and one-month ABC futures contract's theoretical price should be ₹1010 based on futures pricing mechanism discussed earlier.
However, it trades at ₹1020 and seems overpriced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions.
On day 1, buy the security in the cash/spot market at ₹1000. and simultaneously, sell the futures of the security in the futures market at ₹1020.Through a series of similar actions by many arbitrageurs, the price in the spot market will start to increase as a lot of buying is taking place in the same and the price in the futures market will start falling since a lot of selling is taking place in the futures market.
This process of buying in the spot market and selling in the futures market will continue till the spot price and the futures price come to a level at which the spot futures price difference comes back to the theoretically justified levels.
Let’s assume the spot price rises to a level of ₹1005 and the futures price falls to a level of ₹1015 and now the basis is only ₹10 which is justified.
Thus, the arbitrageur now will sell its holding in the cash market at ₹1005, which he had bought at ₹1000 and cover its short position in futures market at ₹1015 where he had initiated a short contract at ₹1020, making an overall profit of Rs.10 (₹5 in cash and ₹5 in futures)
This profit of ₹10 is actually the amount by which the futures price was overpriced compared to its theoretical price when the arbitrageur initiated the trade. This overpricing was because of inefficiency of markets which the arbitrageur capitalized on.
Future is under-priced: Sell spot, Buy futures
A stock, say, ABC Ltd. trades at ₹1000 in the cash market or spot market and one-month ABC futures contract's theoretical price should be ₹1010 based on futures pricing mechanism we discussed earlier. However, it trades at ₹990 and seems under-priced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions.
On day 1, sell the security in the cash/spot market at ₹1000 (if you already own, or else borrow and sell) and simultaneously, buy the futures of the security in the futures market at ₹990.
Through a series of similar actions by many arbitrageurs, the price in the spot market will start to fall as a lot of selling is taking place in the same and the price in the futures market will start rising as a lot of buying is taking place in the futures market.
This process of selling in the spot market and buying in the futures market will continue till the spot price and the futures price come to a level at which the spot futures price difference comes back to the theoretically justified levels.
Let’s assume the spot price falls to a level of ₹990 and the futures prices rise to a level of ₹1000 and now the basis is only ₹10 which is justified.
Thus, the arbitrageur now will buy or cover the number of shares it had sold in the cash market at ₹990, which he had sold at ₹1000 and sell in futures market at ₹1000 where he had initiated a buy at ₹990, making an overall profit of Rs.20 (₹10 in cash and ₹10 in futures).
This profit of ₹20 is actually the amount by which the futures price was under-priced compared to its theoretical price when the arbitrageur initiated the trade. This under-pricing was because of inefficiency of markets which the arbitrageur capitalized on.
