Political Arbitrage Activity

What Is Political Arbitrage Activity?

Political arbitrage activity is a type of arbitrage activity that involves trading securities based on knowledge of potential future political activity.

How Political Arbitrage Activity Works

Political arbitrage activity may be country-specific or region-specific, depending on the type of political activity. Impending government elections in a given country may prompt political arbitrage specific to that nation, while the threat of a war that could encompass a number of countries may trigger political arbitrage across the entire region.

For example, the primary factor in the values of foreign government bonds is the risk of default, which is a political decision taken by a country's government. Thus, the values of companies in regions more prone to war are affected by political decisions. If recent elections are likely to lead to the formation of a government that is not business friendly, a trader may short the benchmark equity index of that country in anticipation of a steep decline.

Arbitrage

Arbitrage is the simultaneous buying and selling of securities or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset. Arbitrage allows investors to profit from an imbalance in the price of a security or asset. Investors profit off arbitrage by exploiting the price differences of identical or similar financial instruments on different markets or in different forms.

Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, and is thus considered to be a risk-free profit for the trader. Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. Fair value refers to the sale price agreed upon by a willing buyer and seller.

Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market, and many traders have computerized trading systems set to monitor fluctuations among similar assets. Due to this advanced technology, investors typically act quickly on any inefficient pricing setups, and arbitrage opportunities. Frequently, price dislocations get eliminated in a matter of seconds.

Example of Political Arbitrage Activity

As an example, if there is a distinct possibility of an imminent conflict in the Middle East, an arbitrageur or trader may short stocks of oil companies based in that region and initiate long positions on North American oil companies.

If traders believe there will be political instability, they could make the above trade in hopes of lower prices for Middle East oil stocks and higher prices for North American oil stocks.