Difference between Arbitrage and Hedging

Arbitrage

Arbitrage is defined as trading on the price difference between multiple markets for a particular good with the aim of making a profit from the imbalance. It involves both the purchase as well as the sale within a very short period of time. If a good is being sold for a lower price in one market and a higher price in another market, a savvy trader can buy that item at the lower price and sell it at a higher price. It helps the trader to enjoy a risk-free return on the transaction.

With the proliferation of high-speed data along with access to constant price information, it is much more difficult to use arbitrage in the financial markets than before. Even then, the arbitrage opportunities can also be found in different types of markets such as bonds, forex, futures and also equities.

Hedging

Hedging also involves the use of multiple concurrent bets in the opposite directions with the aim of limiting the risk of serious investment losses. It is not a pursuit of risk-free trades, but it helps to reduce the known risks that can occur while trading. Forward contracts, options contracts, swaps and derivatives are used by the traders so that they can purchase opposite positions in a financial market. If the trader can bet both against the upward and downward movements in the price of a particular item, they can ensure a certain amount of gain or loss on the trade. This method of betting is particularly important in areas like business management, financial markets and gambling. Like the other risk or reward-related trades, the hedging can result in lower returns for a trader, but it can also offer significant protection against the risk of a downside.

Difference between Arbitrage and Hedging

Both arbitrage and hedging perform a crucial role in the financial markets. Companies can use these financial instruments to look after their monetary needs. However, there are major points of difference between arbitrage and hedging, which we should get a grip on to understand these two instruments:

Arbitrage

Hedging

Definition

Arbitrage is defined as trading on the price difference between multiple markets for a particular good with the aim of making a profit from the imbalance.

Hedging also involves the use of multiple concurrent bets in the opposite directions with the aim of limiting the risk of serious investment losses.

Concept

Arbitrage involves the concept of buying and selling a product based on the price difference.

Hedging involves the concept of betting short versus betting long in the financial markets.

Conclusion

There are a number of points of difference between arbitrage and hedging. But both of them perform a very crucial role in the functioning of the financial markets. Both these financial instruments have a part to play in the overall development and growth of the economy of our country, both in the short as well as the long run.

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