International Arbitrage: Definition, Types & Examples

Key Highlights

• Arbitrage occurs when a security is purchased on one market and sold on another at a higher price.

• Traders can profit from a temporary difference in the prices of identical assets in both markets.

• Arbitrage trading is seen as a relatively risk-free activity.

Understanding International Arbitrage Meaning

Purchasing and selling identical amounts of assets in two separate markets is called "international arbitrage". The principle of price differentials created by market inefficiency is exploited by international arbitrage. International arbitrage is where a trader buys a security from a market at a lower price and sells the same security on another market at a higher price to make a riskless profit.

If both markets are located in the same country, it could be described as "an arbitrage transaction", but according to International Arbitrage Definitions, these two markets should exist within a different country. Due to price differentials reaching equilibrium as soon as they are detected, international arbitrage opportunities are scarce. There will be no place for international arbitrage if there is price equilibrium on the market. The purchase and sale of ADRs, currencies or the same stock listed in two countries represent the most prominent type of foreign arbitrage trading.

Types of International Arbitrage

International arbitrage involves several different types. Interest arbitrage, two-point arbitrage and triangular arbitrage are the three main types of international arbitrage.

1. Covered interest arbitrage

It is known as covered interest arbitrage when the trader uses a forward contract to hedge against exchange rate risks while investing in higher-yielding currencies. The words 'cover' and 'interest arbitrage' are used in a covered interest arbitrage, which means hedging against currency fluctuations while exploiting rate differentials. Complex trading operations and sophisticated arrangements are required in the cover interest arbitrage.

2. Triangle arbitrage

A complicated variation of the two-point arbitrage is the triangle arbitrage, sometimes known as the three-point arbitrage. Instead of two, this involved three currencies or securities. In cases where the exchange rates of three different currencies are at variance, there is a triangular arbitrage opportunity. The trader sells currency 'A's to buy currency 'B's in a global arbitrage called 3 Point International Arbitrage. Then he sells the currency B and buys the currency C. He sells currency 'C' and buys currency 'A' in the last leg of the arbitrage.

3. Two-Point Arbitrage

A two-point arbitrage is an efficient trading technique in which traders buy and sell securities on one market at a higher selling price across geographically different markets. The exchange rate of a currency should be the same worldwide, as far as classical economic theory is concerned. However, there is a price differential due to certain factors, such as the difference in time zones and the lag in the exchange rate. A trader will benefit from the situation by buying or selling on a market that is more advantageous to him than one in which it is cheaper. The exchange rate must be higher than the transaction cost for a gain.

International Arbitrage Example

Let's see what international arbitrage is all about. For instance, the stock of XYZ Inc. is traded on both the New York Stock Exchange and the National Securities Exchange. XYZ's shares are trading on the National Stock Exchange at Rs. 500. However, shares traded at $10.5 per share on the New York Stock Exchange. We assume the exchange rate of USD/INR is 50, which means 1 US$ = Rs 50. The price of shares on the NYSE in INR will be equal to 525 Indian rupees if the exchange rate is current.

In such a case, an investor can simultaneously buy and sell shares of XYZ on the NSE and the New York Stock Exchange to make a profit of Rs. 25 paise per share. In reality, however, the difference is minimal, and ensuring that the favorable exchange rate is maintained for a certain period is necessary. Considering the transaction costs when making an international arbitration decision is crucial. High transaction costs may offset the benefits of arbitrage. Types of Statistical Arbitrage Strategies - H2 Many strategies are classified as statistical arbitrage trading as mentioned below.

1. Market Neutral Arbitrage

This strategy focuses on taking long positions in an undervalued asset and shorting it simultaneously. The long position is expected to increase in value, while the short position will decrease, and the increase and decrease will be the same.

2. Cross-market arbitrage

This model considers differences between the same asset on several markets.

3. ETF arbitrage

This is a cross-asset arbitrage technique whereby differences between an ETF's valuation and its underlying assets are detected. This is done to guarantee that the price of the ETF corresponds with the value of the underlying assets.

4. Cross-asset arbitrage

This model considers the price difference between an asset and its underlying.

Conclusion

Statistical arbitrage in international finance is based on extensive data and mathematical and algorithmic models to exploit price differences between securities. It is based on short-term mean reversion, whereby the price differences up to the point of reversion to the mean levels are considered. To start any kind of stock trading or to open a demat or trading account, check out Kotak Securities.