Risks involved in Arbitrage
Although arbitrage is considered to involve risk-free
profit, there are some risks which may arise in any of the following
situations:
Quick change in prices: While adopting an arbitrage
strategy, it may not be possible to close two or three transactions at the same
instant. Such failure to execute all parts of the transaction simultaneously
can result in a situation where one part of the deal is closed, but a quick
shift in prices makes it impossible to close the other at a profitable price.
Counter-Party Risk: The counter-party to one of the
deals may fail to deliver as agreed. Though unlikely, this is a serious
potential threat in view of the large quantities one must trade in order to
make a profit on small price differences. If leverage or borrowed money is
used, these risks become magnified.
Arbitrage between different assets: Sometimes,
arbitrage transactions are undertaken between items/assets which are not
identical. In spite of the difference in the nature of the assets, the purchase
and sale are made on the assumption that the prices of the articles are
correlated or predictable. In such situations, if price movement is contrary to
ones expectations, it can produce huge losses.
Risk in Market Arbitrage: If one is trying to profit
from a price discrepancy between a stock on BSE and the same stock on NSE, he
may perform one leg of the arbitrage transaction by purchasing a large number
of shares on BSE, but may find that he is unable to sell simultaneously on NSE.
This will expose the arbitrageur to an unhedged risk position.
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