Wednesday, April 29, 2015

Arbitrage 1 - an opportunity for price differentials to converge in financial markets

If an iPad was 10% cheaper in a neighboring state, would you not seize the market opportunity for instant profits? After accounting for costs involved in transportation and other ancillaries, you’d want to grab as much as you can at such cheap prices. Eventually, you’re not the only one. So, demand rises in that cheap iPad state and the price catches up with the rest of the World. That is what economists call arbitrage.

According to, arbitrage can be defined as:
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

Arbitrage is synonymous with making a good buy. It exists due to inefficiencies in a market. Since that is the case, when an arbitrage opportunity is open, it does not last long before the market converges and it disappears.

In the market, prices are accessible in seconds.
Credit: Wikimedia Commons

Availability and access to digital information about markets, prices and supplies is at the fingertips. It is very difficult for the market to allow mispricing or price differences. It usually acts quickly upon pricing inefficiency, so that any opportunity for mispricing is eliminated in seconds.

Yet, some arbitrage does exist in the markets. Mispricing is one of the prerequisites for arbitrage to occur and the fact that prices are deliberately doctored not to converge as by government regulation or corruption. Cases of this arise often in developing economies. If there is a mispricing premium, lobby groups would be created to ensure the price difference is sustained in order to gain an economic advantage. An efficient market would not allow such pure cases of arbitrage to last. Any gain due to mispricing will have to be executed instantaneously by arbitrageurs who close up the gap.

Another prerequisite is for such arbitrage to exist at economies of scale. Given a price premium and trading in volumes that run into millions daily, it is not long before a shrewd company can take advantage of this inefficiency and create an oligopolistic market, if not a monopoly. That setup would be very difficult to dethrone when established. Such company would seek all it can to bar arbitrageurs from getting knowledge or doing business in that market.

In brief, arbitrage and arbitrageurs are good for the economy. They serve as a check against monopolists who would rather price discriminate in order to maximize prices. They ensure that prices converge or are harmonized in markets. They act like a natural law that moves market forces from areas of high prices to areas of low prices. Therefore, consumers and policy makers alike would welcome arbitrage and arbitrageurs.

Arbitrage exists mostly in markets that are speculative in nature, especially in foreign exchange and futures markets.

So, why am I concerned about arbitrage? I read this article on the mobile money Africa site that piqued my interest. The interesting lines are quoted below:
The Central Bank of Nigeria on Tuesday slashed the naira debit cardholders’ spending overseas from $150,000 to $50,000 per annum.

The Managing Director and Chief Executive Officer, Union Bank Plc, Mr. Emeka Emuwa, had after the Bankers’ Committee meeting at the CBN office in Lagos on Thursday, said the amount spent by naira debit cardholders overseas was rising fast and the banks were beginning to notice some arbitra[g]e in the segment.

Nigerian foreign exchange market is composed of two components: the official market that sells and buys at the official CBN rate and the parallel or often called “black” market that sells and buys at rates fixed by markets outside the official sources but whose source of foreign exchange is suspiciously being fueled by sources in the official market.

Why are Nigerians disturbed by arbitrage? That piqued my interest. I did some research in that area.

It is the subject of the second article: Black market and official patronage nullifies arbitrage in Nigerian foreign exchange markets.

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