How they make money out of thin air

A series of statistics carried in the pink dailies scream: "Arbitrage Opportunities".

A friend of yours working as a dealer in an FII brokerage house is difficult to catch hold of as he is busy doing GDR arbitrage.

A big hedge fund that your neighbour works for arbitrages S&P 500 futures and the S&P Index.

"Arbitrage! Arbitrage!!Arbitrage!!!" Ever wondered what this arbitrage is all about?

Why not try and learn it from the streets for a change

Mr. Arb King is a smart smalltime vegetable trader operating in the Juhu (a posh suburban area in Western Mumbai) vegetable market. He is always on the look out for opportunities to buy cheap vegetables from one place and sell them at a higher price in the Juhu market for a good profit. One day, as he was passing through the vegetable market in Santa Cruz (West) (a neighbouring suburb), he heard a vendor cry: "Tomato lelo, bus chhe rupaiya kilo".

Mr. Arb King, who was on his way to his uncle's, stood stupefied as he heard the vendor's cry. They must be out of their minds to sell tomatoes at Rs6 a kilo when I sell the same stuff for Rs9 a kilo just a few kilometers away, he thought. He checked around and discovered that almost all vegetables sold cheaper here, but tomatoes were the cheapest. Maybe people here ate fewer tomatoes than did the rich people in Juhu. Anyway, who cared! Our Mr. King was a trader at heart and he instinctively smelt a profit.

He had a bright idea. Why not buy from Santa Cruz and sell at Juhu. Purchase, say, around 30kg of the stuff at Rs6 a kilo from Santa Cruz and sell the same at Rs9 a kilo in Juhu, where the rich men seemed to have a soft spot for this particular vegetable. It would cost him Rs180 (assuming he would not bargain for a better price, which he would anyway), and he could make a neat profit by selling at Rs9 per kg (Rs270 per 30kg!) in the Juhu market.

 

So, what did Mr. Arb King capitalise on?

Mr. Arb King was not well read but he had enough common sense to figure out that tomatoes at two places not far apart cannot trade at a big price difference.

Your economics textbooks will also tell you that any two similar goods with the same utility function (i.e. the same level of customer satisfaction) should quote at the same price.

What about cost incurred in transporting the tomatoes?

Of course, Mr. Arb King needed to factor in the transport costs between Santa Cruz and Juhu. A cab trip was enough to transport his 30kg of tomatoes.

The cab trip meant an additional cost of Rs30. Mr. Arab King started reworking his margins. It all worked out to a neat profit of Rs60 per 30kg of tomatoes sold! All for just an hour's work! Mr. King's trading instincts were aroused and he set about making a quick buck.

 

What happens if the price difference is actually higher?

Smart traders like Mr. Arb King will notice that there is a profit to be made. Hence, they will buy from the place where the item trades cheaper, to sell it where it commands a higher price, and make a cool profit from the transaction.

Better still, if they can negotiate in such a way that they can execute both ends of the transaction at the same time, then, the business becomes absolutely risk-free. Because under the circumstances, they would not need to worry about any price changes that may happen while they are moving from the lower price point to the higher price point. Literally a free lunch.

Economics text books will call the above set of actions "arbitrage" - an attempt to profit by exploiting price differences of identical or similar goods, in different markets or in different forms. Ideally, arbitrage is a pair of opposite transactions that take place simultaneously and generate profit with zero risk. People like Mr. Arb King will be branded as "Arbitrageurs"

Coming back to our Mr. Arb King. Though a profit of Rs60 per 30kg of tomatoes does appear to be a small amount, imagine if he were to earn such profits every day for a whole year! Do the sums and you will figure out that he would make more than Rs20,000 from nothing! Yes, money from nothing!

 

Give me a break! Can these profits last for long?

You have a point. Let us see what happened at the Juhu and Santa Cruz markets once Mr. King started exploiting the arbitrage opportunity.

Mr. Arb King's frantic selling of tomatoes in the Juhu market without much sweat on his brow did not go unnoticed. One of the other traders, Mr. Jealous Guy, caught up with our King's activities.

He decided to start the very next day to make his share of profits. No sooner decided than done! He got 20kg of tomatoes from Santa Cruz. In order to wean away Mr. Arb King's customers, Mr. Jealous Guy dropped his price to Rs8.5 per kg. This competition went on for a week, bringing down the price of tomatoes in Juhu to Rs8 per kg.

Meanwhile, a vendor in Santa Cruz, sensing the rise in demand for tomatoes, with both Mr. Arb King and Mr. Jealous Guy becoming regular buyers, hiked his price to Rs6.5 per kg. This hit Mr. Arb King's business hard and he saw his profits dwindle from Rs2 per kg to 50 paise per kg. Soon Mr. Arb King walked away in search of greener pastures.

In the meantime, Mr. Me Too got into the act too. In his exuberance, he started selling at Rs7.5 per kg. What are the profits up for grabs now?

The price of tomato in Santa Cruz was Rs6.5 per kg, making the 30 kg of tomato more expensive at Rs195. The transportation cost stayed the same at Rs30. But at a selling price of Rs7.5 per kg, the realization was just Rs225. So sad! No more profits.

At the end of it all, the residents of Juhu got tomatoes at a cheaper price while the vendors in Santa Cruz got a better price for their tomatoes. And the arbitrageurs like Mr. Arb King and Mr. Jealous Guy made hefty profits from their arbitrage, which, in turn, made the market more efficient or a fairer place, where nobody got anything cheaper than anybody else.

Like tomatoes, financial instruments like shares, bonds, futures, et al, can also be arbitraged. In fact, it is easier in case of financial instruments as they are very clearly defined. After all, a share of Reliance is the same whether it is listed on the BSE or the NSE or as a GDR in Luxembourg, as it represents the same percentage of ownership in exactly the same business.

So next time, we will look at how arbitrage opportunities arise despite so much of precision in defining these instruments. We will look at ways to evaluate these opportunities, drawing similarities with our tomatoes anecdote.