What is arbitrage? What does arbitrage mean?
Overview of Interest Arbitrage
Under normal circumstances, the interest rates of various western countries are different. Some countries have higher interest rates and some countries have lower interest rates. The level of interest rate is an important function of international capital activities. Without capital control, capital will cross the border and flow from countries with low interest rates to countries with high interest rates. The international flow of capital must first involve international exchange. Capital outflows must be converted into foreign currencies, and capital inflows must be converted into foreign currencies. In this way, the exchange rate becomes a function that affects capital flows.
Arbitrage refers to the fact that investors or borrowers use the difference between the interest rate of the two places and the currency exchange rate at the same time to make profits by circulating capital. Arbitrage is divided into two types: offset arbitrage and non- offset arbitrage.
Non-compensating arbitrage
Non-compensating arbitrage means that arbitrageurs only use the difference between the different interest rates of two different currencies, and convert the currency with a lower interest rate into a currency with a higher interest rate to make a profit. When the future currency is not sold or bought at the same time, the risk of exchange rate changes is assumed.
In non-compensating arbitrage transactions, the direction of capital flow is mainly determined by the non-compensating spread. Assuming that the interest rate of the United Kingdom is Iuk, the interest rate of the United States is Ius, and the non-compensating interest rate UD, then:
UD ＝ Iuk — Ius
If luk>lus, UD>0, capital flows from the United States to the United Kingdom, and Americans have to convert U.S. dollars into British pounds and store them in the United Kingdom or buy British bonds for more interest. The size of the profit of non-compensating arbitrage is determined by the difference between the two interest rates and the fluctuation of the spot exchange rate. With the spot exchange rate unchanged, the greater the difference in interest rates between the two countries, the greater the profit of arbitrageurs. When the difference between the interest rates of the two countries remains unchanged, the currency with high interest rates appreciates, the greater the profit of arbitrageurs; the currency with high interest rates depreciates, and the profits of arbitrageurs decrease, even to zero or negative.
Suppose that the annual interest rate of the United Kingdom is luk=10%, and the annual interest rate of the United States is lus=4%. The spot exchange rate at the beginning of the year and the spot exchange rate at the end of the year are the same. There is no change in the exchange rate of the pound sterling in one year. ￡1=＄2.80 , The principal of the American arbitrageur is $1000. This arbitrageur converted U.S. dollars into British pounds at the beginning of the year and deposited them in the Bank of England:
＄1000÷＄2.80/￡＝￡357
The interest earned after 1 year is:
￡357×10％＝￡35.7
It is equivalent to $100 (￡35.7×＄2.80/￡=＄100), which is the gross profit obtained by the arbitrageur. If the arbitrageur does not engage in arbitrage and deposits $1,000 in Bank of America, the interest he gets is:
＄1000×4%=$40. The 40 USD is the opportunity cost of arbitrage. Therefore, the net profit of the arbitrageur is $60 ($100—$40).
In fact, in a year, the spot exchange rate of the pound will not stay at the level of $2.8/￡. If the spot exchange rate of the British pound at the end of the year is $2.4/￡, due to the depreciation of the pound, 35.7 pounds can only be converted into 85 U.S. dollars, and the net profit of 60 U.S. dollars will be reduced to 45 U.S. dollars. This means that arbitrageurs buy spot when they make arbitrage transactions at the beginning of the year. When the British pound did not sell the one-year forward pound sterling at a certain exchange rate at the same time, he was willing to take the risk of exchange rate changes, which resulted in a loss of $15 in net interest. From this example, it can be seen that the greater the depreciation of the pound, the greater the loss for arbitrageurs. Of course, if the spot exchange rate of the pound sterling is $3/￡ at the end of the year, the arbitrageur will be too lucky, and his net profit will reach 67 dollars [($35.7×3)=40].
Offset arbitrage
Exchange rate changes can also bring risks to arbitrageurs. In order to avoid this risk, arbitrageurs convert currencies with lower interest rates into currencies with higher interest rates at the spot exchange rate. When banks in countries with higher interest rates or purchase bonds in that country, they also need to transfer the interest at the forward exchange rate. Converting currency with a high rate to currency with a lower interest rate is called offset arbitrage. Take the United Kingdom and the United States as examples. If the interest rate in the United States is lower than the interest rate in the United Kingdom, Americans are willing to convert U.S. dollars into British pounds at the spot exchange rate and deposit them in British banks. In this way, Americans' demand for the pound increased. The demand for the pound sterling increases, and the spot exchange rate of the pound sterling should be increased while other factors remain unchanged. On the other hand, in order to avoid the risk of exchange rate fluctuations, arbitrageurs all sign contracts to sell forward pounds at the forward exchange rate, which increases the supply of forward pounds. The supply of forward pound sterling increases, and the exchange rate of forward pound sterling will fall if other factors remain unchanged. Westerners have come to a conclusion based on their experience in the foreign exchange market: the spot exchange rate of currencies in countries with higher interest rates is on the rise, and the forward exchange rate is on the decline. According to this law, the direction of capital flow is not only determined by the difference between the interest rates of the two countries, but also by the difference between the interest rates of the two countries and the forward premium or discount rate of the currency of the country with high interest rates. The offsetting spread is CD, and the discount rate or premium rate of the pound sterling is F￡, then:
CD ＝ Iuk—Ius 10 F ￡
If the UK interest rate Iuk=10%, the US interest rate Ius=4%, the discount rate of the forward pound F￡=—3%, CD=10%—4%—3%=3%) 0, then capital Will flow from the United States to the United Kingdom. Because arbitrageurs believe that although the forward pound discount reduces their profits, they still have profits to make. If the forward pound discount rate is F￡=-8%, other conditions remain unchanged, CD=10%-4%-8%=-2%(0, at this time, capital will flow from Britain to the United States. Because of arbitrageurs It is believed that the forward pound discount rate is too high, which not only reduces their profits, but also makes their profits negative. The British are willing to convert pound sterling into U.S. dollars at the spot exchange rate and convert U.S. dollars into pound sterling at the forward exchange rate. , Enabling capital to flow from Britain to the United States.
Below, another example is used to illustrate the actual situation of offset arbitrage. Suppose the principal of the arbitrageur is $1000, Iuk=10%, Ius=4%, the spot exchange rate of GBP is $2.8/￡, and the forward exchange rate of GBP is $2.73/￡. Arbitrageurs exchanged U.S. dollars for British pounds at the beginning of the year and deposited them in the Bank of England:
＄1000÷＄2.8/￡＝￡357
The interest earned after 1 year is:
＄357×10％＝＄35.7
According to the forward exchange rate of the contract signed at that time, it is equivalent to $97 ($35.7×$2.73/￡), which is the gross profit of the arbitrageur, from which the opportunity cost of arbitrage is subtracted by $40 ($1000×4%). Arbitrage The net profit obtained by the person is 57 US dollars ($97—$40). This example shows that when arbitrageurs buy spot pounds, they sell pounds at a higher forward exchange rate of pound sterling to avoid losses caused by a sharp decline in the pound exchange rate. After 1 year, the spot pound exchange rate is ＄2.4/￡, arbitrage The person still sells GBP at $2.73/￡.
Arbitrage activities not only enable arbitrageurs to make profits, but objectively play a role in regulating capital flows spontaneously. The high interest rate in a country means that capital there is scarce and it is urgently needed. A country has low interest rates. It means that there is sufficient capital. Arbitrage activities are motivated by the pursuit of profit, which causes capital to flow from places where there is more sufficient to places where it is lacking, and makes capital more effective. Through arbitrage activities, capital continues to flow to countries with higher interest rates, where capital continues to increase, and interest rates will spontaneously drop; capital continues to flow out of countries with lower interest rates, where capital decreases, and interest rates increase spontaneously . Arbitrage activities eventually make the interest rates of different countries tend to be equal.
The imbalance of foreign exchange supply and demand in several important financial markets in the world provides opportunities for foreign exchange transactions such as hedging, speculation, swaps, arbitrage and arbitrage. In turn, these trading activities can spontaneously increase the foreign exchange supply and demand in the world’s financial markets. The relationship tends to be balanced. Equilibrium is always relative, and imbalance is absolute and long-term. Therefore, activities such as value preservation, speculation, swaps, arbitrage and arbitrage are essential transactions in the foreign exchange market. Without these transactions, the foreign exchange market will shrink and it will not play a role in regulating funds or purchasing power.
Overview of arbitrage trading
Arbitrage trading has now become a major trading method in the international financial market. Due to its stable returns and relatively low risk, most large international funds mainly use arbitrage or partial arbitrage to participate in futures or options market transactions. With the standardized development of my country's futures market and the diversification of listed products, the market contains a large number of arbitrage opportunities, and arbitrage trading has become an effective means for some large institutions to participate in the futures market.
Arbitrage trading, also called hedging profit, refers to the use of differences in short-term interest rates in different countries or regions to transfer funds from countries or regions with lower interest rates to countries or regions with higher interest rates for investment in order to obtain a portion of the interest differential income. A foreign exchange transaction refers to the simultaneous buying and selling of two different types of futures contracts.
When conducting arbitrage transactions, investors care about the mutual price relationship between contracts, not the absolute price level. Investors buy contracts that they believe are undervalued by the market and sell contracts that they believe are overvalued by the market. If the direction of price changes is consistent with the original forecast; that is, the price of the contract that is bought goes up and the price of the contract that is sold goes down, then investors can profit from the changes in the relationship between the two contract prices. On the contrary, investors have losses.
The prerequisite for arbitrage activities is that the arbitrage cost or the discount rate of high-interest currencies must be lower than the interest rate difference between the two currencies. Otherwise, the transaction is unprofitable.
In the actual foreign exchange business, the interest rates are based on the interest rates of various currencies in the European money market, mainly based on LIBOR (London inter-bank offer rate). Because, although various foreign exchange business and investment activities involve various countries, most of them are concentrated on the European currency market. The European currency market is an effective way or place for countries to invest.
The role of arbitrage trading in the futures market
Arbitrage trading plays two roles in the futures market:
First, the arbitrage method provides investors with hedging opportunities;
Second, it helps to bring the distorted market prices back to normal levels.
Classification of arbitrage transactions
There are three main forms of arbitrage trading: inter-period arbitrage, cross-market arbitrage and cross-species arbitrage.
Intertemporal arbitrage is the prediction and trading of investors on the relationship between commodity prices in different delivery months;
Cross-market arbitrage is the prediction and buying and selling of the relationship between the price of the same commodity on different exchanges.
Cross-variety arbitrage refers to investors' forecasting and buying and selling of different but related commodity prices in the same delivery month.
According to whether or not a reverse transaction is required to flatten the position during arbitrage, arbitrage transactions can be divided into two forms:
Uncovered interest arbitrage (uncovered interest arbitrage) refers to the transfer of funds from a currency with a low interest rate to a currency with a high interest rate in order to obtain income from the difference in interest rates. This kind of transaction does not have to be carried out in the opposite direction to close the position at the same time, but this kind of transaction bears the risk of high interest rate currency devaluation.
Covered arbitrage (Covered Arbitrage) refers to the transfer of funds to high-interest currency countries or regions while selling forward high-interest-rate currencies in the foreign exchange market, that is, arbitrage while doing swap transactions to avoid exchange rate risks. In fact, this is hedging. General arbitrage transactions are mostly offset arbitrage.
Analysis of the advantages and disadvantages of arbitrage trading
Arbitrage trading has small risks and stable returns. For large funds, if unilateral heavy positions intervene, they will face higher holding costs and greater risks. On the contrary, if unilateral light positions intervene, although risks may be reduced, the opportunity cost is , Time cost is also higher. Therefore, on the whole, it is difficult to obtain a relatively stable and ideal return whether large funds unilaterally heavy warehouses or unilaterally weak warehouses intervene in the futures market. However, if large funds intervene in the futures market with long and short two-way positions, that is, carry out arbitrage transactions, they can not only avoid the risks faced by unilateral positions, but also obtain relatively stable returns.
Advantages of arbitrage trading
1. Lower volatility. Since arbitrage trading obtains the return of the spread of different contracts, and a significant advantage of the spread is that it usually has a lower volatility, so the arbitrageur faces less risk. Generally speaking, the fluctuation of the spread is much smaller than the fluctuation of the futures price. For example, the daily price change of copper traded on the Shanghai Futures Exchange is generally 400-700 yuan/ton, but the price difference between adjacent delivery months is about 80-100 yuan/ton. Many commodity prices are highly volatile and require daily monitoring. The intra-day fluctuation of the spread is often small, and it only needs to be monitored a few times a day or even less. If the funds in an account fluctuate severely, speculators must deposit more money to prevent possible losses. With arbitrage trading, there are few such concerns.
2. Limited risks. Arbitrage trading is the only futures trading method with limited risk. Due to the existence of arbitrage behavior and competition among arbitrageurs, the price deviation between futures contracts will be corrected. Taking into account the transaction cost of arbitrage, the spread between futures contracts will remain within a reasonable range, so there are not many cases where the spread exceeds this range. This means that you can establish arbitrage positions in historical high or low areas based on historical statistics of spreads, and at the same time you can estimate the level of risk to be assumed.
3. Lower risk. Because of the hedging characteristics of arbitrage trading, it usually has a lower risk than unilateral trading. This is an important factor that we need to consider when comparing arbitrage and unilateral trading. Why is the risk lower? Portfolio theory shows that a portfolio consisting of two completely negatively correlated assets minimizes portfolio risk. Arbitrage is the simultaneous buying and selling of two highly correlated futures contracts, that is, a portfolio consisting of two almost completely negatively correlated assets is constructed, and the risk of the portfolio is naturally greatly reduced.
4. Protection of price limit. The hedging characteristics of many arbitrage transactions can provide protection against price limits. Due to political events, weather, government reports, etc., futures prices can rise and fall sharply, and sometimes even cause price limits. Prices are blocked on the price limit and cannot be traded. A unilateral trader who does the opposite will lose heavily before he can close his position. This often results in a shortfall in the trader's account, which requires a margin call. In the same environment, arbitrage traders are basically protected. Taking intertemporal arbitrage as an example, because an arbitrage trader is both long and short on the same commodity, his account usually does not suffer a large loss on the limit day. Although the price difference may not go in the direction predicted by the trader after the price limit is opened, the loss caused by this is often much smaller than that of unilateral trading.
5. More attractive risk/return ratio. Relative to a given unilateral position, an arbitrage position can provide a more attractive risk/return ratio. Although the profit of each arbitrage transaction is not very high, the success rate is high, which is the benefit of the limited risk of the spread, lower risk and lower volatility characteristics. In the long run, only a small number of profitable unilateral transactions are made, and often no more than 3 out of 10 are profitable. Arbitrage is different. It has the characteristics of stable return and low risk, so it has a more attractive return/risk ratio, which is more suitable for the operation of large funds. In the fierce competition between long and short parties holding unilateral positions, arbitrageurs can often intervene at the opportunity to make profits easily.
6. The spread is easier to predict than the price. The price of futures is often not easy to predict due to its large volatility. In a bull market, futures prices will rise unexpectedly high, and in a bear market, futures prices will fall unexpectedly low. Arbitrage trading does not directly predict future price changes in futures contracts, but predict changes in price differences caused by changes in future supply and demand. The latter kind of prediction is obviously much less difficult than the former one. It is very complicated to determine the supply and demand relationship that will affect commodity prices in the future. Although there are rules to follow, it still contains many uncertainties. To predict changes in the spread, you do not have to consider all factors that affect the relationship between supply and demand. Due to the relevance of the two futures contracts, many uncertain supply and demand relationships will only cause the prices of the two contracts to rise and fall at the same time, with little impact on the spread, and this type of supply and demand relationship can be ignored. Predicting the change in the spread between two types of contracts only needs to pay attention to the difference in the response of each contract to the same change in supply and demand. This difference determines the direction and magnitude of the change in the spread.
Shortcomings of arbitrage trading
Everything has two sides, and arbitrage trading is no exception. In addition to the above advantages, there are the following shortcomings:
1. Potential benefits are limited. In the eyes of many investors, the biggest disadvantage of arbitrage is that potential returns are limited. This is normal. When you limit the risks in trading, you will usually also limit your potential returns. However, whether to choose arbitrage trading in the end has to be weighed against the many advantages of arbitrage and the limited potential benefits.
2. Excellent arbitrage opportunities rarely appear frequently. The number of arbitrage opportunities is closely related to the effectiveness of the market. The lower the market efficiency, the more arbitrage opportunities; the higher the market efficiency, the fewer arbitrage opportunities. As far as the current domestic futures market is concerned, the degree of effectiveness is not high, and there are several good arbitrage opportunities for various futures products every year. However, compared with the unilateral trend, there are more arbitrage opportunities every year.
3. Arbitrage also has risks. Although arbitrage has the advantages of limited risk and lower risk, it is risky after all. This risk comes from: the price deviation continues to be wrong. The strong-weak relationship between contracts tends to maintain a situation of "the strong will always be strong and the weak will always be weak" in the short term. If this price deviation will eventually be corrected, arbitrageurs will have to suffer temporary losses in such transactions. If investors can withstand such losses, they will eventually turn losses into profits, but sometimes investors cannot survive the loss period. Moreover, if the short contract encounters a short-squeeze phenomenon and continues until the contract is delivered, the price deviation will not be corrected, and the arbitrage transaction must end in failure.
Arbitrage investment risk source assessment
Successful investment comes from the knowledge and grasp of risks. Like other investments, futures arbitrage investment also has certain risks. Analyzing and evaluating the sources of risks will help correct decision-making and investment. Specifically, the following risks may exist in arbitrage investment:
(1) The spread is moving in an unfavorable direction. Except for the cash arbitrage, the other arbitrage methods are all profited through the change of the spread, so the direction of the spread directly determines the profit or loss of the arbitrage. When we are making arbitrage investment plans, we should fully consider the possibility of spreads running in unfavorable directions. If an arbitrage opportunity spreads unfavorably, the possible loss is 200 points, and the favorable spread may lead to a profit of 400 points, then this The arbitrage opportunity should be grasped. At the same time, stop loss should also be set against possible unfavorable spreads, and strictly enforced. In view of the importance of the risk of the spread, in practice, the risk weight is generally 80%.
(2) Delivery risk. Mainly refers to the risk of whether warehouse receipts can be generated during spot arbitrage and the risk that warehouse receipts may be cancelled and re-examined when doing intertemporal arbitrage. Because the above situation has been considered in detail when making an arbitrage plan, and the After careful calculation, we give this risk a weight of 10%.
(3) Risks of extreme market conditions. Mainly refers to the risk of forced liquidation by the exchange when extreme market conditions occur. With the increasingly standardized futures market, this type of risk has become smaller and smaller, and this risk can also be avoided by applying for hedging and other methods. Therefore, it is also given a weight of 10%.
Why choose arbitrage trading
Arbitrage trading is different from price unilateral trading in its counterparts and trading strategies. There is no absolute pros and cons between the two. It is an investment trading channel independent of unilateral trading. The choice between the two depends largely on the investor's risk appetite, investment risk and capital size.
In general, arbitrage trading involves a much smaller change in the price difference between contracts than the price change of a single contract, which is a trading method with low risk and stable returns. Therefore, arbitrage trading is mainly an investment choice for traders with large amounts of funds or a stable style. Below we explain the overall advantages or characteristics of arbitrage trading.
Hedging the uncertainty of related commodities
(1) Lower volatility and risk
Compared with a single commodity, arbitrage trading hedges part of the uncertain factors that affect price changes. Therefore, in general, the fluctuation of the spread is much smaller than the fluctuation of the price, and the arbitrageur faces less risk and reduces Less pressure on investors' capital management.
(2) Limited risks
For those arbitrage that has a corresponding spot operating mechanism, it can also achieve limited risk, or even theoretically no risk. For example, if the price of the storable commodity's recent contract is lower than the forward contract, and the spread is higher than the holding cost of the commodity, you can buy the recent contract and sell the forward contract for arbitrage. Even when delivery is approaching, the spread between the forward contract and the recent contract widens, and arbitrageurs can choose to buy and deliver in the near future and sell in the forward. Therefore, this arbitrage is a limited risk arbitrage. This is also commonly referred to as "cash and carry arbitrage".
(3) Form protection for price limit
The hedging characteristics of many arbitrage transactions not only form a hedge against day-to-day price fluctuations, but also protect the price limit. For example, due to political events, major accidents, weather, government reports and other emergencies, futures prices will rise and fall sharply, or even up or down. At this time, the reverse position will suffer heavy losses before closing, and even cause transactions. The account is short. Under the same conditions, arbitrage traders are basically protected, and the losses caused are often much smaller than unilateral transactions.
(4) Risk/benefit ratio is more attractive
Compared to a given unilateral position, an arbitrage position can provide a more attractive return/risk ratio. Although the return of each arbitrage transaction is not very high, the success rate is high, which is determined by the limited risk of the spread, lower risk and lower volatility characteristics. In the long run, only a small number of profitable unilateral transactions, and often only 3 out of 10 profit. Arbitrage is different. It has the characteristics of stable return and low risk, so it has a more attractive return/risk ratio, which is more suitable for the operation of large funds.
Arbitrage is a trading strategy independent of speculation
Objectively speaking, there are no absolute advantages and disadvantages between investment methods. The choice of investment method depends to a large extent on investors' risk appetite, investment risk and capital size. Arbitrage trading is a trading method with less risk than unilateral trading and stable returns. The corresponding trading object and the trading strategy formulated are different from unilateral price trading, so it is an alternative investment transaction method different from unilateral trading.
In general, arbitrage transactions involve much smaller changes in contract spreads than the price changes of a single contract, and there are more profit opportunities. At the same time, arbitrage uses "two legs" to walk. Therefore, arbitrage trading is often the main investment choice for traders with large amounts of funds or stable styles. In fact, based on the characteristics of stable arbitrage returns and more investment, funds are a good way to carry out arbitrage transactions and obtain arbitrage profits.
From www.fundfund.cn detailed text reference: http://www.fundfund.cn/news_2008727_20318.htm