Concept of Arbitrage - In Tinku's way

      Our hero Master Tinku is fond of chocolates. He usually takes money from his father pocket and buy almond chocolates in a shop near by their house at Rs.10 per chocolate. One fine day Tinku's father took him to his aunts house, on the way tinku asked his father to get him chocolates. So they went to a shop and puchased 2 chocolates, his father paid Rs.16. Our little hero watched this and realised that he was cheated by the shopkeeper. As and when he reached home, he immediately pushed off to the shop keeper and asked him.

The shop keeper replied " My dear boy, i purchase them at Rs. 9 per piece so i can't sell at less than Rs.10".

An idea flash into Tinku's mind to purchase from a shop near to his aunts house and sell it here.

Now tell me who is Tinku ?

Each and every one of us is Tinku and if we know the opportunity , surely we will exploit that opportunity to make gain, and this opportunity is known as ARBITRAGE opportunity.

Coming to the concept, Arbitrage means simultaneous purchase and sale in two separate financial markets in order to profit from a price difference existing between the markets. There are various ways of making profit out of arbitrage opportunity.

1. Domestic arbitrage in spot maket: Usually most of the companies shares are  quoted in more than one exchange. A particular company share can be bought or sold from any stock exchange. When a particular security is mis-priced from one market to another, arbitrage opportunities creep up.

Suppose Infosys scrip is priced at 103 in NSE and 108 in BSE, then we can buy from NSE and sell in BSE.

Points to be noted:

•  Brokerage at the time of buying and selling has to be calculated.
• Both Long and Short positions are to be entered at the same time,         otherwise the prices may change.
• You should have an inventory of such security/scrip because to sell/short you should have the scrip with you.( If you already have 100 shares of Infosys then short 100 @ 108 and long 100 @ 103, as a result your inventory didn't change and you ended with profit, net of brokerage)
•  Some brokers won't permit to do so in the same day.
• As the profit is in rupees, the shares has to be traded in lots ( >1000) to raise a huge profit from such transactions.

2. Domestic arbitrage from spot market to futures market: The steps are as follows

•  A particular scrip has to be compared in spot market and futures market. ( If Infosys is traded in spot market @ 100 and 3 months future price is 115)
• Compute a fair futures price i.e., if you purchase it now and hold it until 3 months. All you have to do is add your interest to the spot price ( suppose your int. rate is @ 24% p.a, For 3 months it is 6% and Fair futures price = 100+6 = 106)
•  If fair futures price is less than actual future price then enter into futures contract to sell and buy in the spot market( Now, you will be ended with a profit of 9 per share after 3 months)
•  But remember Futures contract are only in lots (> 1000)

3. International arbitrage: Same as domestic arbitrage but between a domestic market and a international market.

Note: There are still various types of arbitrage and which are advanced to understand, so i am not presenting in this article.