Concept of hedging and arbitrage

What is Hedging?  

Hedging involves of an investor taking a position in one market to offset losses by taking a position in a contrary market. An investor can protect his open position from the risks of future price movements. This is particularly true when the underlying portfolio has been built with a specific objective in mind, and unexpected movements in price may place those objectives at risk. 

In the stock market, three types of hedging are used which include futures contract, forward contract, and money markets. 

A futures contract refers to the purchase of an underlying for delivery on a future date. A futures contract enables a buyer or a seller to buy or sell a stock, commodity, or interest rate, for delivery on a future date. 

A forward contract is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. Forwards are widely used in commodities, foreign exchange, equity, and interest rate markets. 

The money market is a part of the financial market where instruments with short-term maturities (less than one year) are traded. The money market instruments consist of call (overnight) and short notice (up to fourteen days) money, commercial paper, certificates of deposit, money market mutual funds as well as commercial and treasury bills. 

The most commonly used strategies in hedging are asset allocation, portfolio structuring, and using call/put options.  

What is Arbitrage?  

Arbitrage involves the act of buying a security in one market and simultaneously selling it in another market at a higher price. Arbitrageurs are specialist traders who evaluate whether the difference in price is higher than the cost of borrowing. If so, they would exploit the difference by borrowing and buying in the cheaper market and selling in the expensive market. 

Arbitrage can be used across various financial instruments like options, shares, commodities or foreign exchange or derivatives. The types of arbitrages include risk arbitrage, retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage. 

A simple and the most common example to explain the concept of arbitrage is – 

Suppose, company ABC is listed on both - New York Stock Exchange and London Stock Exchange. ABC’s stock is trading at USD 50 (£ 36.50) on London Stock Exchange and at USD 50.50 on New York Stock Exchange. If the arbitrageur buys that stock at London Stock Exchange and simultaneously sells at New York Stock Exchange, he will earn a profit of USD 0.50.