Arbitrage vs. Relative Value

Arbitrage exploits price discrepancies in identical assets in different markets to secure risk-free profits (given perfect conditions).

The “arb” strategy hinges on the ability to execute transactions quickly to exploit these temporary mispricings. This makes it a low-risk, low-return approach.

Relative value strategies focus on identifying price mismatches between related but not identical assets. It relies on the expectation that the price ratio will revert to its historical mean or something that’s deemed more fundamentally sound.

Relative value has higher risk and potential for higher returns due to the reliance on analytical predictions rather than guaranteed discrepancies.

Both strategies are significantly influenced by market liquidity and volatility.

These factors affect the ability to execute trades effectively and the persistence of the price anomalies they rely on, and in turn shapes the success potential of arbitrage and relative value trades.

Key Takeaways – Arbitrage vs. Relative Value

• Arbitrage typically exhibits a lower risk/lower return profile compared to relative value’s higher risk/higher return characteristics.
• Successful execution and speed are vital for arbitrageurs.
• Relative value strategies require in-depth analysis and an understanding of the market variables that may affect the price convergence.
• Market volatility and liquidity are critical factors affecting the success of both types of strategies.

Here’s a breakdown of arbitrage and relative value strategies, along with their roles in finance:

Explanation of Arbitrage

Definition

The purest form of arbitrage involves the simultaneous purchase and sale of an identical asset in different markets to exploit fleeting price discrepancies.

This offers a truly risk-free profit opportunity.

Rarity

True arbitrage opportunities are rare and short-lived.

Market efficiency (prices reflecting all available information quickly) tends to eliminate them rapidly.

The nature of algorithmic trading and speed of execution makes it difficult.

Pure Arbitrage

• The classic definition of arbitrage. An asset is simultaneously bought in one market and sold in another where it commands a higher price.
• In theory, there’s zero risk involved as the profit is essentially locked in.
• These opportunities are extremely rare and fleeting due to market efficiency.

Risk Arbitrage

• Exploiting price discrepancies that may occur during events likely to affect security prices, such as mergers, acquisitions, or liquidations.
• Involves greater risk, as the outcome of the event is not guaranteed. For instance, a merger could fall apart, leaving the arbitrageur with a loss.

Key Characteristics

Risk-free profit in theory

True, pure arbitrage promises risk-free profits, which explains the relentless search by traders.

Exploits market inefficiencies

Arbitrage thrives on temporary mispricings and discrepancies between markets. Arbitrageurs help restore market efficiency by correcting these imbalances.

Examples of Arbitrage

Commodity Arbitrage

If gold is trading at $1,800 an ounce on the New York exchange and $1,801 on the London exchange, an arbitrageur could buy in New York and simultaneously sell in London, locking in a $1 per ounce profit.

Currency Arbitrage

Exploiting differing exchange rates of a currency across markets.

For example, if the EUR/USD exchange rate is different in New York vs. Frankfurt, an arbitrageur could capitalize on the discrepancy.

Covered Interest Arbitrage

A more complex strategy exploiting interest rate differentials, exchange rates, and forward contracts on currencies.

Arbitrageurs seek to capture interest rate differences while hedging against currency risk.

Related: Interest Rate Parity

Important Consideration with Arbitrage

Real-world frictions

While arbitrage sounds simple, in practice, transaction costs, time delays, and liquidity constraints introduce some risk and reduce the potential for pure risk-free gains.

The role of technology

Algorithmic trading and high-speed systems now dominate the search for arbitrage opportunities.

Accordingly, individual day traders often find these opportunities difficult to exploit.

Explanation of Relative Value (RV)

Definition

Relative value strategies involve identifying mispricings between related assets, rather than identical assets.

These assets often exhibit historical correlations in their price movements.

Or there might be a lack of historical correlation, but the trader recognizes something that likely isn’t sustainable in the long run.

Traders seek to profit from the expected convergence of these prices back to their normal relationship.

Example

Suppose Stock A is trading at 8x earnings and Stock B is trading at 50x earnings and is unlikely to execute on its growth vision.

The trader might go long Stock A, perceiving it as undervalued, and short Stock B due to overvaluation.

Risk

Because they involve assets that are similar, but not identical, relative value strategies carry more risk than true arbitrage.

There’s no guarantee the price discrepancy will indeed correct itself.

Concept of Fair Value

At its core, RV investing is based on identifying securities that are believed to be mispriced relative to their “fair value” as determined by the trader’s analysis.

This analysis typically considers:

• Comparisons to similar securities
• Historical pricing relationships
• Company fundamentals (e.g., earnings, growth prospects)

Long/Short Strategies

RV investors often employ long/short strategies, meaning:

• Long: Buying assets perceived as undervalued relative to peers, expecting their prices to rise.
• Short: Selling assets perceived as overvalued, expecting their prices to fall.
• This helps isolate the potential profit from the mispricing, minimizing the impact of broader market trends.

Key Characteristics

Seeks to Exploit Price Discrepancies Between Related Securities

Not identical assets like in pure arbitrage, but assets with correlations (e.g., stocks in the same industry, bonds with similar maturities).

Involves More Risk than Pure Arbitrage

No guarantee that the expected price convergence will occur.

The analysis of fair value and the timing of the mispricing are subjective.

Examples of Relative Value Strategies

Here are some examples:

Fixed Income RV

• Yield Curve Trades – Analyzing the relationship between bonds of different maturities along a yield curve to potentially exploit anomalies and expected shifts in the curve’s shape.
• Credit Spreads – Identifying discrepancies in credit spreads between similar corporate bonds or between corporate and government bonds that may signal mispricing.

Equity Index Pair Trades

• Betting on Relative Performance – Taking long and short positions in indices with high correlations (for example, the S&P 500 and the Dow Jones Industrial Average), expecting one to outperform the other.
• Sector Rotations – Identifying undervalued and overvalued sectors within a market, going long on the former and short on the latter.

Considerations in Relative Value

RV investing comes in many forms.

The examples above are just a few illustrations.

Relative value strategies span different asset classes and exploit various types of mispricings.

Success relies on:

• Fundamental analysis to determine fair value.
• Understanding historical relationships between the traded assets and how they’re expected to behave on a forward basis.
• Patience as price convergences can take time.

Key Differences

Comparison of Risk Profiles (Arbitrage vs. Relative Value)

Arbitrage

• Lower risk (in theory) – Pure arbitrage, with its simultaneous buying and selling of identical assets, should carry minimal risk. Any price discrepancies are temporary mispricings the arbitrageur tries to exploit.
• Execution is key – True arbitrage profits are often tiny. Successful traders need to execute flawlessly and with “lightning” speed to secure profits before the price discrepancy disappears.

Relative Value

• Higher risk – Mispricings here are based on the investor’s own analysis. There’s no guarantee that the market will agree with their assessment of fair value or that the prices will converge as expected.
• Potential for higher returns – The increased risk in RV opens the potential for larger profits if the trader’s analysis is correct and the timing of the expected price convergence is accurate.

Roles in Financial Markets

Let’s look at the role of each in financial markets.

Arbitrage

Market Efficiency

Arbitrageurs contribute to market efficiency – aligning asset prices across markets and limiting the persistence of mispricings.

Liquidity

Arbitrage often adds liquidity to markets, as these traders buy and sell simultaneously.

Relative Value

Discovering Mispricings

Relative value traders analyze assets to try and identify under and overvaluations that may not yet be widely reflected in market prices.

This can lead to a correction of mispricings.

But it’s less guaranteed than true arbitrage because the assets are dissimilar.

Risk Management

Relative value strategies are often employed by hedge funds seeking to reduce exposure to overall market movements.

By going long and short on related assets, they attempt to isolate the specific mispricing opportunity from broader market trends.

Having low correlation from traditional asset classes is a big part of the appeal of many hedge funds.

Technical Tools

Statistical Models

• Arbitrage – Statistical arbitrage often uses complex models to screen huge amounts of market data for fleeting mispricings. These models look for temporary deviations in prices that can be exploited.
• Relative Value – Statistical and regression models are used to analyze relationships between assets, establish historical correlations, and pinpoint potential pricing anomalies.

Derivatives

• Both Strategies – Options, futures, and other derivatives can be used to establish positions, hedge risks, or leverage gains.

For example, covered interest arbitrage relies on forward contracts to address currency risk.

Skills Required

Quantitative Analysis

Both strategies depend on the ability to:

• Analyze vast amounts of financial data (e.g., pricing, historical trends, macroeconomic factors).
• Develop/implement statistical models to identify pricing discrepancies and relationships.

Fast Decision-Making

Particularly important in arbitrage, where opportunities disappear fast.

Traders need the ability to:

• Rapidly assess potential trades.
• Decisively execute orders to capture profits.

Most true arbitrage trading is done with algorithmic systems.

Additional Considerations

Programming and Technology Proficiency

Expertise in programming languages (Python, R) and database management are often important for handling large datasets and automating analysis and trading systems.

Arbitrage: The Speed Factor

Arbitrageurs may invest heavily in low-latency trading infrastructure to gain a competitive edge in speed, as profits can evaporate in milliseconds.

Most arb/HFT systems are written in C++.

Relative Value: Fundamental Skills

While statistical analysis is important, a deeper understanding of asset fundamentals and company financials is important in determining fair value and mispricings.

Day Trading Specific Considerations

Arbitrage opportunities for individual traders are becoming increasingly rare due to algorithmic trading and the dominance of professional players.

Relative value still presents more potential openings.

Quiz: Arbitrage vs. Relative Value Trading Strategies

Let’s take a “arbitrage or relative value” quiz to test our understanding.

And note that just because “arbitrage” is in the strategy name doesn’t necessarily mean it’s arbitrage in practice. 🙂 

There’s also not a clear-cut answer in each case.

Situations

1. Gold-Silver Ratio Trading – Buy silver and short gold when the gold-silver ratio is historically high, expecting it to revert to the mean.
2. Triangular Currency Arbitrage – Exploit discrepancies in exchange rates between three currencies to lock in a risk-free profit.
3. Convertible Bond Arbitrage – Buy convertible bonds and short the underlying stock to exploit price discrepancies between the bond and the stock.
4. Interest Rate Arbitrage – Borrow in a country with low interest rates and invest in a country with higher interest rates.
5. Merger Arbitrage – Buy stock in a company being acquired and short the stock of the acquiring company, betting that the deal will go through.
6. Commodity Spread Trading – Go long on crude oil and short on heating oil when the price difference is expected to narrow.
7. Statistical Arbitrage – Use quantitative models to identify mispricings in stocks, taking long and short positions accordingly.
8. ETF vs. Underlying Assets – Exploit price differences between an ETF and its underlying assets by buying the undervalued asset and shorting the overvalued one.
9. Options Arbitrage – Use put-call parity to identify mispricings in options markets, establishing positions to capture risk-free profits.
10. Fixed Income Arbitrage – Trade long and short positions in different bonds to exploit yield curve discrepancies.

Answer Key

1. Gold-Silver Ratio Trading: Relative Value
   • This strategy relies on the historical relationship between gold and silver prices and their expected reversion to the mean.
2. Triangular Currency Arbitrage: Arbitrage
   • This is a classic arbitrage strategy that involves no market risk, aiming to exploit discrepancies in exchange rates.
3. Convertible Bond Arbitrage: Combination
   • This strategy combines arbitrage (exploiting bond and stock price discrepancies) and relative value (taking advantage of market mispricings).
4. Interest Rate Arbitrage: Arbitrage
   • This involves taking advantage of interest rate differentials between countries with minimal risk if done properly.
5. Merger Arbitrage: Relative Value
   • This strategy is based on the expected convergence of stock prices post-merger announcement and carries some risk.
6. Commodity Spread Trading: Relative Value
   • This involves speculating on the price relationship between two commodities, typically within the same sector.
7. Statistical Arbitrage: Can be both
   • This strategy uses statistical models to find and exploit mispricings in stocks, based on their historical price relationships. In such a case, it’s relative value.
   • If it’s correcting the difference between, for example, an ETF or the underlying assets like the next example, then arbitrage.
8. ETF vs. Underlying Assets: Arbitrage
   • This strategy involves buying the undervalued asset and shorting the overvalued one to capture a risk-free profit when prices converge.
9. Options Arbitrage: Arbitrage
   • Using put-call parity to find mispricings in options markets is a classic arbitrage strategy.
10. Fixed Income Arbitrage: Relative Value
    • This strategy exploits discrepancies in bond yields and prices, based on their relative values along the yield curve.