Arbitrage vs Hedging
Traders in today’s marketplace continuously use various tactics to obtain higher levels of return, and to ensure that the levels of risk suffered are minimized. Arbitrage and hedging are two such measures, which are quite different to each other in terms of the purpose for which they are used. The following article provides a clear overview of each type of technique and explains the difference between the two.
Arbitrage
Arbitrage is where a trader will simultaneously purchase and sell an asset with hopes to make a profit from the differences in the price levels of the asset that is bought and the asset that is being sold. It must be kept in mind that the assets are bought and sold off different market places; which is the reason for the differences in the price levels. The reason as to why there are differences in price levels in different markets is because of market inefficiencies; where even though the conditions in one market place have resulted in a change, in price levels, because this information has not yet impacted the other market place the price levels remain different. A trader looking to make a profit can use these market inefficiencies to their advantage by merely buying the asset at a cheaper price from one market and selling it off at a higher price afterwards to make an arbitrage profit.
Hedging
Hedging is a tactic used by traders to minimize possible risk, and thereby loss in income resulting from changes in the movement, in price levels. An investor will hedge against possible losses by entering into an investment that allows the investor to take a position to offset any losses, in the event that the worse happens. It acts like a security measure, or an insurance coverage against suffering substantial losses. Hedging can be done by financial instruments such as stocks, futures, options, swaps and forwards, and usually employ complex investment strategies such as short selling and taking long positions. Hedging can be understood better with an example.
Airlines consistently purchase fuel to run their operations. However, the price of fuel is extremely volatile and so most airlines attempt to guard against this risk by taking on a hedge that sets the price of fuel at a maximum cap. This can be done through financial instruments such as a swap or option.
Arbitrage vs Hedging
Arbitrage and hedging are both techniques that are used by traders that operate in a volatile financial environment. However, these techniques are quite different to each other and are used for different purposes. Arbitrage is usually used by a trader who seeks to make large profits through market inefficiencies. On the other hand, hedging is used by traders as an insurance policy to guard against any potential losses. Arbitrage and hedging are similar to each other in that they both require investors to anticipate movements in the market and use financial instruments to benefit from those movements.
Summary:
• Traders in today’s marketplace continuously use various tactics to obtain higher levels of return, and to ensure that the levels of risk suffered are minimized. Arbitrage and hedging are two such measures, which are quite different to each other in terms of the purpose for which they are used.
• Arbitrage is where a trader will simultaneously purchase and sell an asset with hopes to make a profit from the differences in the price levels of the asset that is bought and the asset that is being sold.
• Hedging is a tactic used by traders to minimize possible risk, and thereby loss in income resulting from changes in the movement, in price levels.