Question

If the market is illiquid what might happen when you try to close the arbitrage triangle? This is an example of pure arbitrage, what is quasi-arbitrage? What is speculation? What is a hedge? Can you use a hedge on a quasi-arbitrage to move to a pure arbitrage? Why or why not? (e.g. risk-return (cost) relationship).

Answer 1

An Arbitrage Triangle is taking advantage of the three different exchange rates involving three different currencies in the foreign exchange market. For example let's say 1 USD (US Dollar) = 70 INR (Indian Rupee) and 1 INR = 2 Japanese Yen. Hence, an forex participant will get 70 INR for giving 1 USD. Now, for 70 INR, he will get 140 (70 * 2) Japanese Yen. And let's say 1 Japanese Yen = $ 0.009, hence 140 Japanese Yen will give (140 * 0.009 i.e. $1.26). Thus, there is a net arbitrage profit of $ 1.26 - $ 1 i.e. $ 0.26 respectively per $. Now, if the market becomes illiquid of let's say 1 Yen = $ 0.009, then due to illiquidity and lower market demand for US dollars from Yen currency, the exchange rate moves on to 1 Yen = $ 0.007. Let's say at this exchange rate market becomes liquid, then in this case net return to the arbitrager will be ( 140 * 0.007 i.e. $0.98 - $1). Thus, he will incur a loss of $ 0.02 per $. Thus, market illiquidity can convert a profit situation into loss and can also make the buyer unable to close his position for a considerable period of time. For example, if the market is still illiquid at 1 Yen = $ 0.007, then the arbitrager will have his mark to market losses increased further.

In textbook terms, Arbitrage Triangle is an Pure Arbitrage i.e. attaining risk less or risk free profits. Quasi Profit Arbitrage on the other hand implies replacing an asset position with another position having equal risk and higher possible expected return. For example replacing an stock's buy position with another stock's buy position having equal volatility but higher possible return. This can be due to difference in the price of two securities with first security being expensive and the second one being cheaper respectively.

Speculation means taking positions in financial instruments like bonds and stocks with the expectation of these instruments rising/falling in the future. The securities can fall if you have taken a buy position and can rise if you have taken a sell position, leading to loss in both the cases. Hence, speculation involves risk element and profit expectation both in the future.   

Hedge is defined as taking a reverse position in an underlying asset in one market as compared to its position in the other market. For example, let's say an investor has taken a positional monthly buy trade in stock A at $ 100 expecting the price to go up to $ 105 in thirty days. But if the stock goes below $ 100, investor will suffer a loss. Hence, as a protection against this loss he takes a sell position in the Futures of Stock A which are trading at $ 105. If the price of the stock goes to $ 98, let's say then his futures position profit will be ($ 105 (Futures Price) - $ 98 (spot/cash price) i.e. $ 7). His loss in cash/spot market, where he initially bought the stock at $ 105 will be ( $ 98 (spot price) - $ 105 (spot price) i.e. $ - 7). Hence, in net he will incur zero loss/profit i.e. - $ 7 + $ 7 = NIL. Hence, by hedging investor was able to avoid his loss completely in this case. Thus, hedge enables the investor to protect his/her losses.

Hedging involves limiting or avoiding the losses while arbitrage, any type for that matter involves attaining risk free profit by taking advantage of price differential between two or more markets. Hence, hedging can involve loss and thereby more risk as compared to arbitrage, which only involves taking risk free profits in the pocket. Hence, hedging on Quasi Arbitrage i.e. replaced asset position as highlighted above in Quasi Arbitrage section will not make it move on to Pure Arbitrage.