What is Arbitrage? Is the assumption of No Arbitrage realistic?
Arbitrage is a trading strategy that takes advantage of price disparities or inefficiencies in different markets to make a profit. There are various types of arbitrages.
Spatial Arbitrage: Traders simultaneously purchase and sale same asset in different markets to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms. Pure arbitrage exists because of market inefficiencies. It both exploits and resolves those inefficiencies and adds liquidity to market.
Temporal Arbitrage: Traders anticipate a rise in an asset’s price. They buy an asset when the price is lower and sell it later when the price has increased.
Statistical Arbitrage: Statistical arbitrage, also known as pairs trading, involves identifying mispriced relationships between two or more correlated assets. Traders buy an undervalued asset and sell an overvalued one with the expectation that the prices will eventually converge. Statistical arbitrage is heavily reliant on computer models and analysis and is known as one of the most rigorous approaches to investing.
Merger Arbitrage: Involves trading the stocks of companies involved in mergers and acquisitions. Traders speculate on the price difference between the current stock price and the price the acquiring company offers during the acquisition process.
Dividend Arbitrage: Traders use this strategy around the ex-dividend date to capture dividend payments by buying the stock just before the ex-dividend date and selling it shortly after.
Currency Arbitrage: Currency arbitrage capitalizes on differences in exchange rates between different currency pairs.
Commodity Arbitrage: Commodity arbitrage involves exploiting price differences for the same commodity in different markets.
Triangular Arbitrage: Triangular arbitrage occurs in the foreign exchange market, where traders take advantage of exchange rate discrepancies between 3 different currencies to make a profit.
Arbitrage opportunities are often short-lived as market participants quickly exploit the price discrepancies, bringing the prices back into alignment. This is the main reason why no arbitrage assumption is used to build financial theories. So, it’s not that arbitrage opportunities don’t exist, but that they are assumed to be exploited very quickly and driven away.
The root of arbitrage is information asymmetry. Not all market participants have access to the same information, which can lead to disparities in pricing that persist for a period. Insider trading involves trading in a public company's stock or other securities by someone with non-public, material information about the company.
Although the STOCK Act passed in 2012 prohibits federal lawmakers and staff from trading on insider information or nonpublic knowledge gained by way of their government positions, members of Congress have frequently violated it with few consequences. They file their trade disclosures late, improperly report them, or fail to report them altogether. In early 2020, four senators were accused of using insider information about the corona virus pandemic to profit in the stock market. In May 2020, Justice department ends inquiries into these senator’s stock trades.
There are a lot of publications by finance media about trading activities and performance of Congress members and it’s easy to see a list of stock traders who beat the S&P500 each year. Thus, this is not a new issue but there is no stricter law governing it. Although there is no official charges brought against Congress members regarding their trading activities, it erodes public trust in their ethical standards and call into questions the assumptions of no arbitrage opportunity.
Reference Source: