Risks Associated With Arbitrage

Arbitrage is generally considered to be risk-free as it takes advantage of the difference in the prices of an asset in two or more markets and respective imbalance in similar deals. The profit in arbitrage is the price difference between the compared markets. The risk is downgraded here because you are trying to sell the asset in a different market by overcoming the cost price incurred in one, that is, selling at a price higher than the price at which you bought it. It is almost natural that you are able to get a profit of some degree due to this difference as the transaction cost is balanced and exceeded while selling it.

All that is not true

The concept of arbitrage primarily evokes a feeling that you are trading in a no-risk zone, but nothing comes safely. You can become susceptible to risks here also when the gap between prices fluctuates (minor, reducing the profit margin) or any asset gets devalued (major). The day-to-day risk is minimal here since the price gap in a single day usually tends to be small, and even if you lose, it will be small. In rare and extreme cases, these risks can push you into financial crisis or even bankruptcy, when you are trading on borrowed money or when there is a large price move. Further, these risks are classified into:

Execution Risk: This is a type of day-to-day risk and occurs when you have multiple transactions to be completed simultaneously. You may fail to complete any or some parts of these transactions and there may be quick fluctuations in the prices that eventually result in a loss.

Counterparty Risk: A type of rare risk in which you cash in on the future transactions with a counterparty and the party fails to complete the transaction.

Liquidity Risk: Another type of rare risk when you fall out of money to continue holding onto one or more assets and are forced to give a put option. The asset may be expected to trade well in the future, but the current crisis gives you no other way except to sell it.

Risk Due To Mismatch: This happens in convergence trade when you trade in different items based on the assumption that their prices can be correlated, but lead to surmounting losses.

Therefore, application of mind and remaining vigilant hold the key to success even in this ‘risk-free’ business.

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