Introduction
We all know that neighbourhood Aunty who buys sarees on the cheap in her hometown and sells it at a premium in the city to her friends and acquaintances.
You possibly also know that savvy housekeeper who buys produce at rock-bottom prices, when in season, and stores them for the year ahead.
Both of the above are everyday examples of Arbitrage and Hedging - strategies used by savvy investors to make profits in the market. Both these strategies are linked to the share price or the price of an underlying asset. But, the similarity ends there.
Read on to understand some fine nuances that distinguishes arbitrage from hedging. This will help you understand when and how to employ these strategies.
What is Arbitrage?
Sometimes, investors spot a difference in prices in two different markets and employ a strategy and gain from it. Such a strategy in which investors invest to gain from the difference in price of an asset in two different markets is called arbitrage.
Arbitrage is all about making money with minimal risk by taking advantage of price differentials or market inefficiencies. Put simply, if a security trades at two different prices in two different markets at the same time; then one can buy it in a market where it is quoting at a lower price and sell it in the market where it is quoting at a higher price. By doing so, an arbitrageur profits from the price differential.
How is an arbitrage strategy executed?
In the good old days, investors would buy a stock from one stock exchange and sell it on the other. When prices converged, they would reverse their positions and pocket the difference. Over a period of time, with the use of computers and algorithmic trading, the price differential has reduced.
Spot future arbitrage, however, is still a popular means to making risk-free profits. This is done by many mutual funds, institutional investors, individuals and the proprietary desks of some broking houses. A stock is bought in the cash or spot market and sold at a higher price in the futures market simultaneously. The price differential is captured at the time of entry. Towards the end of the month, prices converge in spot and future markets. At that time, positions are reversed and profit is realised.
This strategy is widely used by equity mutual fund schemes and balanced advantage fund schemes which are expected to maintain gross exposure to equities of minimum 65 percent. Spot future arbitrage is considered to be an equity investment for mutual funds, and can be of help, when a fund manager does not find adequate investment opportunities in stocks or the asset allocation model calls for lower investments in stocks.
Another popular arbitrage trade is merger arbitrage. This is done by savvy investors, hedge funds and alternative investment funds. In a merger arbitrage, traders sell the acquirer company’s shares and buy the target company’s shares based on the swap ratio and the time frame of the transaction. This requires a well-thought out transaction strategy using stock futures.
Though arbitrage involves trading in stocks or derivatives, investors are not exposed to movements in the broad market. It is one of the ‘non-directional’ strategies, which means the pay-offs are not dependent on price movements in the stock markets.
Returns from arbitrage vary from time to time. Spot future arbitrage typically earns returns in line with returns offered by money market returns. In a volatile market, if futures are quoting at a discount to the spot, then spot future arbitrage involving buying in spot and selling in futures is not profitable. Investors have to also account for transaction costs – brokerage and other statutory levies while executing arbitrage strategies. High transaction costs can make arbitrage trading unviable.
While arbitrage strategies can help you earn some risk free returns, hedging is done to manage risks.
What is Hedging?
Sometimes, an investor senses a fall in the value of the investments, and acts to preserve the value of the investment. Such a strategy used to prevent erosion in value of their investments is called hedging.
Hedging is all about taking an offsetting position in the market to reduce risks. Hedging is done by mutual funds, institutional investors and high networth individuals with large portfolios. Hedging helps investors contain the downside risk in their portfolios.
How is hedging done?
Hedging can be done by buying put options, when you have a large stock portfolio or a long position. Some investors prefer to sell futures on the index taking into account the beta of their portfolio. Beta here is a measure of the market risk faced by a stock or a portfolio or how much a stock in question moves with every unit moved by the index.
If the market sentiment changes and it moves in the opposite direction than you envisaged, then your trade or position starts incurring losses. But if you are holding an appropriate hedge, then it starts generating profit. Such an offsetting arrangement can help to contain the downside in your position.
Hedging investors have to understand the beta of a portfolio and risks involved. A hedge needs to be carefully chosen after taking into account factors such as liquidity of hedging instruments and the costs associated with a hedge.
Conclusion
Experts point out that investors have to understand both these strategies fully. They say that arbitrage is all about being alert to opportunities in markets. On the other hand, hedging is all about the sense of capital preservation when opportunities are either cashed in on or are not easily available.