2nd December 2025
Medium Link: https://medium.com/@gyvishwanath/arbitrage-in-financial-markets-d584951f9ed2
Course Relevance
This caselet is designed for the following PGDM / MBA courses:
- Investment Management: Covers investments, arbitrage and risk,
- Financial Derivatives : applies finance concepts to futures, forwards and swaps
Academic Concepts
- This caselet draws on multiple applications of arbitrage opportunities in financial markets.
- It talks about profit making in stocks using locational advantage
- It discusses calender spread
- It cover forex markets for arbitrage
- Triangular arbitrage is covered.
Explores how feedback Arbitrage in financial markets means the practice of taking use of price differences between two or more markets for the same asset. For example, if there are price differences between a share at NSE and BSE, say Maruti, one can buy in the exchange where the price is less and sell the share in exchange where the price is more. Suppose, Maruti is traded in Nse at 15800 and 15850 at BSE, we can buy in NSE and sell it at BSE. We can net a profit of Rs.50 per share. However, there would be transactions cost involved.
The reasons for arbitrage opportunities are many. It could be information mismatch, insider information, network issues, technical issues or it could be just so many stocks are followed by traders, few big traders miss what’s happening in other shares. As we have more than 5000 companies traded in the Indian markets, these kinds of discrepancies occur. Also, ADR and GDR of Indian companies are traded in international markets and this also leads to arbitrage opportunities due to time differences. But, the key advantage is that this is a risk free profit which investors can make use of.
There are two types of arbitrage like spatial arbitrage which exploits the price differences between geographic locations. Second is temporal arbitrage which refers to the different time periods
Key factors connected to arbitrage:
1. Market Efficiency: Arbitrage opportunities are often very short, as markets tend to correct price discrepancies immediately. It means the investor need to be very agile to utilize the opportunity.
2. Transaction Costs: Arbitrageurs must consider transaction costs, such as brokerage fees and taxes, which can erode profits, however nowadays brokerages being very low it actually does not matter.
3. Risk Management: While arbitrage is thought as risk-free, there are risks associated with market volatility, liquidity, or settlement. For example, you can buy in one market and before you sell the price can crash on the long side. Some times when you purchase in a place say a 1000 shares and there are no buyers for 1000 in the other market, where you would be able to sell only say 200 shares. Hence it requires deep market knowledge and procedural expertise to effectively utilize it. Sometimes due to settlement we may not be able to use the opportunity.
Uses of Arbitrage
Arbitrage is the reason for the prices attaining equilibrium in financial markets. Arbitrageurs help eliminate price differences, ensuring that assets are fairly valued across markets
Improving Liquidity: Arbitrage activity can increase trading volume and liquidity in markets. Because of arbitrage as per research, nearly 25 percentage of the volume is generated by the arbitrage trades.
Arbitrage in Forex Markets
Arbitrage in Forex refers to the practice of exploiting price discrepancies in currency exchange rates between different brokers, markets, or instruments.
Types of Forex Arbitrage:
1. Triangular Arbitrage: Exploiting discrepancies in exchange rates between three currency pairs.
2. Two-Currency Arbitrage: Taking advantage of price differences between two currency pairs.
3. Latency Arbitrage: Profiting from temporary price discrepancies due to latency in price feeds.
Example:
Suppose Broker A quotes EUR/USD at 1.05000, while Broker B quotes it at 1.1050. An arbitrageur could buy EUR/USD from Broker A and sell it to Broker B, pocketing the 0.0010 difference as profit.
Covered interest arbitrage :
This is a method in forex market using interest rate differences. For example, if there is a difference in interest rate between two currencies in two countries, theoretically we can borrow in the country where interest rate is low and invest in a country where it is high and make a profit.
This is an example of covered interest arbitrage:
Assumptions:
-Currency pair to use : USD/GBP (US Dollar/British Pound)
-Spot exchange rate: 1 USD = 0.80 GBP quoted in London
-1-year forward exchange rate: 1 USD = 0.82 GBP in London
– 1-year interest rate in the US: 2% (NewYork)
– 1-year interest rate in the UK: 4% (London)
Steps in Covered Interest Arbitrage Strategy:
1. Borrow USD 1,000,000 at 2% interest rate for 1 year in Newyork.
2. Convert USD 1,000,000 to GBP at the spot rate (1 USD = 0.80 GBP) in London: GBP 800,000.
3. Invest GBP 800,000 in the UK at 4% interest rate for 1 year: GBP 832,000 (interest calculated as 800,000 x 1.04).
4. Enter into a 1-year forward contract to sell GBP 832,000 at the forward rate (1 USD = 0.82 GBP): USD 1,014,634 calculated as (832,000 / 0.82).
Arbitrage Profit:
1. Repay the USD loan: USD 1,020,000 (1,000,000 x 1.02) with interest.
2. Receive USD 1,014,634 from the forward contract invested.
3. Arbitrage profit: USD 1,014,634 – USD 1,020,000 is not profitable in this direction. Hence we have to use the opposite method.
That would be
1. Borrow GBP 800,000 at 4% interest rate for 1 year in London.
2. Convert GBP 800,000 to USD at the spot rate (1 USD = 0.80 GBP): USD 1,000,000 in Newyourk.
3. Invest USD 1,000,000 in the US Newyorkat 2% interest rate for 1 year: USD 1,020,000.
4. Enter into a 1-year forward contract to buy GBP 832,000 at the forward rate (1 USD = 0.82 GBP): USD 1,014,634. This would lead to a profit
Challenges and Considerations:
1. Market Efficiency: Forex markets are highly efficient, making arbitrage opportunities very short.
2. Transaction Costs: Commissions, spreads, and other costs can erode profits for small traders. Only large traders like banks can effectively utilize.
3. Technological Requirements: Sophisticated trading platforms and algorithms are necessary to detect and exploit arbitrage opportunities, but glitches in the systems may lead to big risks.
4. Risk Management: While arbitrage is often considered risk-free, all the problems we discussed earlier applies to forex markets too.
Necessary Tools and Strategies required for arbitrage traders ;
1. Automated Trading Systems: Using algorithms to detect and execute arbitrage opportunities is mandatory to use the opportunities.
2. Real-time Price Feeds: Access to accurate and timely price data is crucial for arbitrage which means robust internet connectivity and powerful computers and trained employess for organisations..
3. Multiple Broker Accounts: Having accounts with multiple brokers can facilitate arbitrage as there could be several restrictions on trading in some of the companies. As discussed earlier, we require advanced technical expertise, sophisticated trading tools, and a deep understanding of market dynamics.
Teaching Note :
This topic is relevant for the international Finance and derivatives course studied by the PGDM2 students. This covers what is arbitrage and how to make profit using this strategy. As we have discussed arbitrage is a risk free trading opportunity and traders can use it for making profit without undertaking huge risk.
Learning Objectives
After engaging with this caselet, students will be able to:
- Analyze how arbitrage works
- Apply concepts in real markets
- Evaluate the risk and return of strategies.
Key Discussion Points
- Importance of timing in arbitrage
- How to control risk in arbitrage
Discussion Questions :
- How arbitrage opportunities are created and how traders can exploit?
- Explain the Covered interest arbitrage with INR/USD example.
References :
Adams, J. & Montesi, C. J. (1995): “Major Issues
Related to Hedge Accounts.” Financial Accounting
Standard Board – Business & Economics.
2. Bollerslev, T. (1986). “Generalized Autoregressive
Conditional Heteroskedasticity.” Journal of
Econometrics, 31(1), 307-327.
