Understanding the difference between Hedging and Arbitrage

Introduction:

The financial market has become very successful in the last few years with the evolution of technology and its inputs.There is also the need for the risk management techniques and they have been also well placed for the smooth functioning of the financial sector as a whole.

The stock market trading and also its day-to-day deals have become more in number and also very unique in their functioning. All this calls for the strategies which are effective to deal with these stock changes at a larger level. In order to swim across the tide times in the investment sector, we have the basic two modules to help us. They are Hedging and Arbitrage functions. These two play an essential role in managing investment risk to a great detail.

Role of Hedging:

Meaning and concept– hedging is the use of financial instruments to reduce the effect of investment risk with help of another investment. Investors hedge by procuring two securities that are negatively correlated, thus providing the risk from price changes in the volatile market.

It is not a risk-free trade but a trade with minor risk in it. This makes complete sense of satisfaction for traders to trade. Some of the common methods are option contracts, forward contracts, futures contracts, swaps, and derivatives. These are used to for betting against the upward as well as the downward movements in the market and help the hedger to experience minimal loss.

Hedging is essential in the financial market, gambling and business management though it can be used anywhere for risk aversion. Therefore by actively using the derivatives, the hedging function reduces the potential loss which traders may face.

Role of Arbitrage:

Meaning and concept: Arbitrage is a method of simultaneously investing in securities to prevent the loss of money during price fluctuations in the stock market. More clearly to explain, it is buying a security in one market and investing it in another market to be free of the price changes in both markets affecting the investment.

Arbitrage ensures that price doesn’t change a long way from their fair value at which it can be traded easily. This has also been a solution to eliminate risk in automate trading setups too and has helped the investors to keep monitoring which stock to buy and sell simultaneously.

There are many types of arbitrage functions to suit the different price movements in the market.

Now that the clear difference has been understood, trading in such markets which are risk-prone becomes easy with help of hedge and arbitrage functions.