Speculation v/s Arbitration v/s Hedging

Arbitrage

Arbitrage is the act of buying and selling an asset simultaneously in different markets to profit from a mismatch in prices. Arbitrage opportunities arise due to the inefficiency of the markets. Arbitrage is a common practice in currency trade and stocks listed on multiple exchanges. For instance, suppose the shares of company XYZ are listed on the National Stock Exchange in India as well as the New York Stock Exchange in the US. On certain occasions, there will be a mismatch in the share price of XYZ on the NSE and NYSE due to currency fluctuations. Ideally, after considering the exchange rate, the share price of XYZ on both the exchanges should be the same. However, stock movements, the difference in time zones and exchange rate fluctuations create a temporary mismatch in prices. Seizing the opportunity, arbitrage traders buy on the exchange where the share price is lower and sell the same quantity on the exchange with the higher share price.

Arbitrage opportunities are very short-lived as markets have been designed to be highly efficient. Once an arbitrage opportunity is used, it quickly disappears as the mismatch is corrected. While arbitrage is more common in identical instruments, many traders also take advantage of a predictable relationship between instruments. Generally, the price of a mismatch is exceedingly small. To profit from a small price differential, traders must place large orders to generate adequate profits. If executed properly, arbitrage trades are relatively less risky; however, a sudden change in the exchange rate or high trading commission can make arbitrage opportunities unfeasible.

Speculation

Every trade is based on the expectation of the investor. The markets function only because someone is willing to buy and someone on the other end is willing to buy. The seller generally expects the price to fall and sells to monetise his profit, while the buyer expects the price to rise and hence enters the counter to generate returns. Speculation is the broad term for trading based on expectation, assumption or hunch. The speculation involves considerable risk of loss. The primary driver of speculation is the probability of earning significant profits. Speculation is not limited to financial instruments; it is common in other assets also. For instance, speculation is common in the real estate market. Extreme speculation leads to the formation of asset bubbles like the dot com bubble in the early 2000s and tulip bubble in medieval times. The profit margin can be high in speculative trades, so even small traders can trade based on speculation.

Arbitrage vs speculation

Arbitrage and speculation are two different financial strategies. The major differences between arbitrage vs speculation are the size of the trade, time duration, risk and structure. Only large traders can take advantage of arbitrage opportunities as they are short-lived, and the profit margin is small which requires scale. Speculation doesn’t have any such limitations; even small traders can place bets based on speculation. Speculative trades can last anywhere from a few minutes to several months, but the same cannot be said about arbitrage trades. Arbitrage opportunities arise due to market inefficiencies and disappear as soon as someone utilises it. Arbitrageurs buy and sell the same asset simultaneously. The simultaneous nature of arbitrage trade limits the risk for the trader. On the other hand, the risk of loss remains high in the case of speculative trade as speculative price movements are based on the assumption of many people.

Arbitrageurs

Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions, although the life of the assets and, hence, the consummation of the profit may be delayed until some future date. The key element in the definition is that the amount of profit be determined with certainty. It specifically excludes transactions which guarantee a minimum rate of return but which also offer an option for increased profits. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets (Eg : NSE and BSE) . If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Hedgers

Hedging is the simultaneous purchase and sale of two assets in the expectation of a gain from different subsequent movements in the price of those assets. Usually the two assets are equivalent in all respects except maturity. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.

Speculators

Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Day traders are speculators. NB : While Hedgers look to protect against a price change, speculators look to make profit from a price change. Also, the hedger gives up some opportunity in exchange for reduced risk. The speculator on the other hand acquires opportunity in exchange for taking on risk.