FutureIQ Knowledgebase

Be Rich or Go to Jail - Arbitrage Explained Simply with Examples - FutureIQ

2,199 views Wait, is this logic right? • Dec 30, 2023
Open in YouTube
Slog Reference: Understanding Arbitrage

Description

What is arbitrage? It’s a simple question to answer. But the answer gets interesting when you bring examples. Understanding arbitrage becomes much easier as soon as you understand when and where it applies. So, let’s find some real-life examples and stories of using the benefit of arbitrage on the stock market, currency exchanges, and other parts and find out what exactly arbitrage is.

More videos for you:
Supply & demand: https://youtu.be/imweTGK0Myk
Opportunity cost: https://youtu.be/fgtiC6RkRwg

Hope you enjoyed FutureIQ by Navin Kabra and Shrikant Joshi. Do hit us up on Twitter:
@ngkabra http://twitter.com/ngkabra
@shrikant https://twitter.com/shrikant

Listen it on the podcast provider of your choice: https://tapthe.link/FutureIQRSS
Watch other episodes of The FutureIQ podcast: https://www.youtube.com/playlist?list=PLAppTB0r5_TaYueZ0adD42Wiw5X-wTE4v

Chapters:
00:00 Introduction & example
02:41 Arbitrage
03:37 Ponzi scheme
07:37 SBF & arbitrage
07:27 Indian example - FoodPanda
13:18 Example 4
14:10 Example 5
15:18 Example 6
18:30 Moral of the story
20:05 Arbitrage & risk
24:15 The solution
24:37 The summary

#futureiq #arbitrage

Related Slog Matches

Understanding Arbitrage

Vector

60.37

Transcript

Shriant, did you know that Infosys stock can be bought on many different stock exchanges like National Stock Exchange, Bombay Stock Exchange or even New York Stock Exchange? I am not very well wellversed with share trading. But I'll take your word for it. Yes. Can it have different prices on the different stock exchanges? Like you know when I'm going to buy vegetables, I'm like I ask this guy and he says, "Okay, 25 rupees." And then I ask the next one and see if he's willing to give for 20 20 rupees. and so on. Can you do that?
Ignoring the fact that he just compared stocks to vegetables and the only stock I know is vegetable stock. Bad joke. But it doesn't make sense to do that, right? If I can buy See, if vegetables can be at different prices on different markets, I'm not going to sell the vegetable back. Are you okay? Sorry. I'm going to consume the vegetable with stocks. I'm planning to sell them back eventually. So, if there's a difference in stocks, I can easily make profit right away. like buy it at a exchange that is selling lower and sell it at an exchange that is buying higher.
You know what? Uh they are on to you. They don't allow such things. Right? If you buy a stock uh on national stock exchange, you have to sell it on national stock exchange. You're not allowed to sell it on BSC. Did you know that? I did not know that. But that makes sense then. So now can they be at different prices? Uh I'm pretty sure they can't be because there is Why? Because it's the same stock, right? Right. I mean that you're talking as if it's like you know the whole world is logical. It's not.
Yeah. I I have no idea. Can they? Well, the simple thought experiment is this, right? Let's assume that it is at 1350 on the NSE. Okay. Okay. And 1,400 on the BSE. Okay. But I can't sell the NS stock. But let's say there are BSE people on BSE who have say 10,000 uh shares of Infosys. Why wouldn't they just sell their 10,000 shares at 1,400 and buy 10,000 shares at 1350 on the NSE and now they have a cool 50 lakh five lakh rupees profit for zero risk.
Yeah. Because it's at the end of the day it's stock of it's a share of Infosys. So you're still getting the same share in the company. Correct. Exactly. I mean when I'm buying bindi from this guy versus that guy I can say that this bindi is better quality. There are no Infosys shares that are better quality when you go into different exchange, right? I mean technically there are but not these ones. Yeah, it does make sense for the share prices to be different in different exchanges even in that's the concept we are going to discuss today's uh on today's episode.
It is called arbitrage. When the exact same thing is available in two different places for two different prices, that's called arbitrage. And unless there is a good reason for those prices to be different, that means that you can buy here, sell there at the same time and make risk-free money. What what I've noticed is usually when the prices are different, then the products are also different. Correct? If the products are the same, the prices are also usually the same. Correct? They have to be. Yeah. Because if they are not then someone somewhere will figure out figure this out and they will find a way of making money without any risk. Right. And they will go and make money like
Yeah. Because business at the end of the day is buy low and sell high. Correct. So in fact um there are some great examples of this in history. Okay. Okay. So the first Ponzi scheme you know heard of Charles Ponzi. We have done an episode on it in the past. Right. Yeah. was it started off as an arbitrage opportunity. Okay. So, uh in those days people used to write letters and they would stick stamps on the letter and they would post it. Him calling it those days makes me sad because this is basically my childhood he's talking about and his his childhood also. What am I saying?
Those days and but to send international letters you needed international stamps which were expensive. They were the international community came up with a very interesting idea. Huh. What they said was that you have something called international reply coupon. Okay. Okay. So if a business in US sends a letter to somebody in Italy to a customer and they want the customer to reply uh right they don't want the customer to have to spend money for replying. You know there was there used to be these business reply envelopes. Now something similar uh was there right? But the US business needs to be able to buy uh international stamps in Italy and so on. Correct?
So the international community came up with a standard concept called international reply coupon that you can buy in any country and use in any country. Okay. Now the tricky part is that US is a rich country. There the international ruply coupen costs more. Yeah. Whereas Italy is a poorer country and it costs much less in Italy. Correct. And now suddenly there is arbitrage because exactly the same thing is usable in both places. And what Charles Sponszi figured out was that he could buy cheap international reply coupons in Italy, ship them to the US, sell them in US.
Wait, they were cheaper than the cost of buying in Italy plus shipping. Well, so there we will come to that. Okay. uh shipping when you do it in bulk uh does you know cost very little per unit. Uh in fact in another episode we will discuss how shipping an apple from New Zealand to here adds very little to the cost of that apple. But we'll come back to that. Okay. What Charles Ponzi figured out. If we've already had that episode ready, you will see a link in the description.
If not, keep watching this space. Like and subscribe for more etc. One problem here is that first you need to have money to buy in the first place, right? Because this is a numbers game. This is a volume game, right? You need to buy a large amount and then here you have to sell it and you make money, correct? And usually if you had a large amount, then you wouldn't be trying to make money like this, right? So where do you get the large amount of money from?
Uh you get a loan from someone and because this is risk-free money, ah loans are much easier. Correct. But Ponzi didn't even do that. What he did was he just pitched it as a business opportunity to customers. He said, "You give me $10,000. I will give you 15,000 back." Right? Or whatever amount of money. He said, "I will double the investment in 90 days." Right? So he would take $10,000 from so many people, take all of it, buy a large amount of international reply coupons in Italy, ship it to the US, sell it, and from the proceeds give them double their money back in 90 days.
Wow. Right. Okay. So that's he was he was making way more than double. Wow. Correct. So we will come to that later. But basically understand the idea. The same thing, an international reply coupon which can be used to send an international letter from any country to any country was cheaper in Italy, expensive in the US, two different prices in two different places and there was an opportunity called arbitrage and Charles Swanson tried to take it. There was an opportunity to buy low and sell high and he did that.
Take me take another recent example. Okay, Bitcoin. Okay, you get a Bitcoin in India, Bitcoin in US, Bitcoin in Japan. It's the same thing. It can be used from anywhere. I mean, you can put it do blockchain transactions from anywhere in the world. Correct. But for some reason, okay, like 5 years ago, there were the Bitcoin prices in the US were around $10,000, but in Korea it was around $15,000. In Japan also, it was a little like 12,000 or something like that. Okay. Okay. And the reason being that there were laws in Japan and Korea against having too many bitcoin and doing transactions in bitcoin because of which it was more difficult to deal with uh
bitcoin there. Right. So this was called the kimchi prebium by the way. Okay. Slightly racist but okay racist names are the most memorable. Right. So it was called the kimchi premium. No, that's No, no, that is one of the reasons they're racist is No. So, one guy at the age of 29 became a billionaire by taking advantage of this arbitrage. He would buy Bitcoin in US sell it in Japan. Well, for in Korea for a little while, then he gave up. Then he started doing it in Japan, sell it in Japan and pocket the difference. Okay. Do you know the name of this person who became a billionaire at 29 by doing Bitcoin arbitrage?
Wait, is it that FTX guy? Yes. Sam Bankman Fried SBF of FTX. Wow. That is how billionaire. Of course. Of course they became a billionaire. But hold on a sec. These are all international examples you're giving. You want an India example? Of course I want an India example because Indians are honest that way. No. Yes. Yes. Of course. So a great example. Okay. So you might have heard of food panda. Okay. Okay, it was an ordering app similar to Swiggy and Zumato. Okay, now Food Panda had gotten investment from a venture capitalist. Okay, so now they want to grow their business very fast. What is one good way of growing business very fast to get new users,
give out lots of discounts, correct? So they had a 30% discount. You order from any restaurant and you get a 30% discount for using food partner instead of going to the restaurant. Okay. So let's say it's you order $1,000 worth of,000 rupees worth of stuff. I was worried he was ordering $1,000 worth of food. No, we're coming to that. We're coming to that. Okay. So 1,000 rupees worth of stuff if you order from like a di kitchen. Okay. Restaurant in Pune, you pay Well, no it was in Delhi. This was happening in Pune.
Yeah. But anyway, huh. This was happening in this actually happened in Delhi. Okay. Okay. And you'll know why it happened in Delhi more than in Pune. So you order 1,000 rupees worth you pay 700 to Food Panda. What is the restaurant expecting? 700. No, the restaurant is expecting a,000. Correct. So food panda takes 300 from their pot of money that the VC gave adds it to the 700 gives it to the restaurant. Okay, that's how the whole system works. Correct? And as long as that pot of VC money is there, the system works.
Correct? Now Delhi people at least there are some Delhi people okay who when they see an arbitrage opportunity they jump on it. Listen we have to make it clear that it's not just Delhi people it's people. Okay. Yes, people all over the world. Examples are there from everywhere. But this is what they did. Okay, create a fake restaurant which doesn't exist. Okay, there is a menu which is added to Food Panda. Okay, from there now you sit at your computer. You order 1,000 rupee worth of stuff from this restaurant. Food Panda sends uh the order to the restaurant saying so and so person has ordered it. Please deliver it to so and so location. You
send back wait half an hour then send back a message to food panda saying yes food has been delivered. Okay food panda didn't have its own people. Well I mean this is a asset light business right that the restaurant has its own delivery people and does it own delivery. Example, even if you order uh from Domino's on Swiggy, Domino's delivers. Swiggy doesn't deliver. It's a different deal. Asset light that's called. Okay, fine. I'm learning. I'm learning entrepreneurship and business also with future IQ. You learn everything with future IQ.
You also have to not wave your hands. Go on. Right. So now uh what this person has doneh okay is took 700 rupees from their pocket give it to food panda food panda added 300 rupees of the VC money and returned it to the restauranter which is the same guy 50% profit more roughly 50% profit because 700 plus 300 at one time huh there were 400 fake restaurants on food pala doing this I'm not surprised Okay. But basically this can be done because there is an arbitrage.
Correct. It's an arbitrage opportunity where you are buying food at 700 but getting back 1,000 bucks. Correct. Exactly. Yeah. Wonderful. So arbitrage opportunities that's a whole bunch of them. I can uh give you more examples. Right now imagine that there is some local store here in Pune in own. Okay. And he's going out of business and selling say these Mattel toy cars at 30% discount. Oh okay. Right. You see this and you see this as an opportunity. Absolutely. You buy from him and then you put it online on Amazon or eBay. Lots of people did it sold things like this on eBay.
Whenever there is a discount scheme going on somewhere, you buy it from the retailer, put it online and sell it uh online. Early days of eBay, lots of people made money uh like this because they saw arbitrage opportunities because the online price was at some level and if someone somewhere saw an offline price lower than that, they used the opportunity and made uh money, right? Absolutely. Let me give you some more fun examples of arbitrage, right? Okay. Whiskey. If you try to buy a whiskey in Maharashtra versus in Goa or any alcohol, yeah, it is much cheaper in Goa. Do you know why?
Because excise duties are different in the two states. Exactly. Maharashtra has a much higher excise duty on alcohol. So I'm sure you have friends if ever they go to Goa, they just load up on liquor bottles and bring them back to Maharashtra. Right. There is a hitch. They don't really bring them back because they get caught and stopped. They don't bring them back because they're buy and on the way just drink them all. No comments on that. But typically on the border they are stopped and then the bottles are counted and all of that happens.
So we wait you're making my friends out to be drunk people. Naven are you a drunk person? No no no no. I'm making your friends out to be smart people who sell it after they come to Maharashtra and pocket the difference. Right. That's arbitrage. Yeah but there is the risk of them the we'll come to the risks. Okay. But let me finish with one more very interesting example. Okay. Okay. So imagine there is an IndiaPakistan World Cup match happening. Okay. And both teams seem evenly balanced. One has better batting, another has better bowling and so on.
Right. Now there is betting going on. Correct. Okay. Now the betting shops in India think India is going to win because that's what all their customers are uh betting for on. Right. So what happens is that the odds are such that the Indian betting shops say that you give us 100 rupees and if you bet on India winning then we will and India actually wins you'll get back 150 correct whereas if you bet on Pakistan winning and Pakistan actually wins you get back 250 and of course if your bet doesn't come true you get nothing they keep the 100 rupees right correct now if it is like this pay 100 get 150 for India 250 for Pakistan.
Mhm. There is no way you can make risk-free money doing this, right? And if you know beforehand Pakistan is going to win or even India is going to win, you can make money. But if you don't know beforehand, there is a good chance you will lose. Uh that is what the odds are for, right? That's what the odds are for. There's no risk-free uh way of making money. Correct? In Pakistan, however, the sentiment is exactly the opposite. Okay? So the Pakistan betting shops are saying give us 100. If Pakistan wins and you have that's what you bet on you get back 150.
The numbers for India are 250. So you bet on India and India. Exactly the opposite scenario because they are now as soon as this happens you can see that there is an arbitrage opportunity here. Absolutely. Can you see how you can make 100% guaranteed way of making money by this bet on the opposite team in the other country just I mean in India bet on Pakistan in Pakistan bet on India same amount no so very simple example you take put 100 rupees here in India and say Pakistan will win you put 100 rupees in Pakistan and say India will win and you get beaten up from both countries it's worth it because you get 250 rupees
is right. Let me see. It's worth it worth a beating. No. Uh, no. If you know anything about betting, you know that you're going to borrow 10 cr rupees and put it and then get 25 crores back. Okay. This guy speaks in numbers that are alien to me. 10 crores. He says 10. Just let's make sure we understand the maths, right? You put 100 here, you put 100 there. If India wins, okay, this money goes away. The one in India goes away zero but you get 250 from Pakistan correct on an investment of 200. If the opposite happens the Pakistan money goes away but in India you get 250 on an investment of 200. So
rupees profit straight out. A better way of saying it is that it is 25% profit risk-free in one day. You want to annualize that return. No I don't know. I don't it's just that India and Pakistan don't play matches every single day of 365 days. The annualized return will be a different category. They're not getting into the math of it. What would be the moral of the story? Don't bet or you get beaten up. No, unless you want it, right? Yeah, it's absolutely worth it. No, the point is that the odds will never really be like this.
That's Yeah, right. Because someone somewhere will figure this out and they will make money, right? there enough havala stuff going on across India Pakistan also. So it means that whenever there is a arbitrage opportunity like that by arbitrage I mean same thing two different prices in two different locations and then someone can exploit that opportunity and make risk-free money then someone will make risk-free money and that until and they will keep doing that until the opportunity goes away. Why will the opportunity go away? By the way, because somebody will exploit it to a point where the opportunity will no longer be feasible for either one of the two parties involved in the transaction.
Exactly. See, if you are making risk-free money, then somebody is losing money getting nothing in return. Correct. At some point, that person will either raise their prices or go out of business. Yep. Correct. So that is the basic moral of today's uh episode that there are no arbitrage opportunities that you can just go and exploit like that. Right? If you more like there are never permanent arbitrage opportunities. There are sometimes temporary arbitrage opportunities if you manage to step in at the right time like Sam Bankman Freed managed to step in at the right time.
The food but scammers managed to step in at the right time. So before that let's talk about I mean I've been saying that you know this is a risk-free way of making money. Usually if an arbitrage opportunity is there and it hasn't disappeared by the time you noticed it, it means that it is not risk-free. There is something you are missing. Right? Let's put all our earlier examples and uh make sure we understand what the issue is. Right? So why are the liquor prices different in Maharashtra and Goa?
Because excise is different. But it also means that it is illegal to transport liquor from Goa to Maharashtra. Which is why Goa can keep their prices low and Maharashtra can keep their otherwise I mean you know entire businesses would be set up just to buy everything in Goa and then bring it to Maharashtra and sell it. Goa would be left with no alcohol which is not which is not a very good idea. It is illegal which means that people who try to take like case loads of alcohol across the border every once in a while they get caught by the border police and those guys confiscate the entire lot lot and then you end up losing far more
than you were making. Right? That's the risk. Hasn't happened to me. I'm just Never mind. Go on. Yeah. The liquidity kimchi premium that SBF right we already hinted at that right. it was there were a whole bunch of little things there that were slightly illegal and painful and uh SBF being the kind of person he is sort of managed those things nobody else wanted to do it that way in the long term these things don't get managed right exactly proper anyway uh another example we go back to Charles Ponzi okay yeah what happened there because as far as I can see it was a clean thing yeah so one thing you brought up yourself right which is that you have to
ship it from there to there is a cost okay I said it's low but still there is some cost so the transaction costs shipping costs the costs overheads of getting it from that place bringing it here and selling it those you have to take into account so for example uh the bindi in my locality in costs far more than the bindi in marketard correct why because for people who don't know marketyard is the wholesale market in puni. Okay. If I went and bought bindi in marketard I would make money right absolutely but then I have to take it from there I have to transport it to and then I have to try to sell it in and if I don't
manage to sell everything by the end of the day the parts that I didn't sell are wasted. So I have to uh also account for the wastage and usually that wastage will be a significant amount significant amount and of course I can't sell it unless I sit there for one whole day with that basket and I have to account for the dollar uh value of your time dollar value of my time right so there are overheads although in Bitcoin it's easier but correct but still there are so there there were significant overheads both in Bitcoin and in Charles Ponzi's scheme.
Well, in Ponzi's case, it wasn't the overhead wasn't the money needed for shipping, although there was some of it because for and what was the overhead when you bring it here, you have to actually sell so many. Ah, I mean, if you buy like the entire year's output of uh postage stamps from Italy, and then you want to sell it in one month in the US, that's not going to happen. Correct. Uh, right. Correct? Because more and more people are investing in your scheme because you are giving doubling the money in 90 days.
But you can't keep that up. You can't keep buying more and more of those postage stamps. You're going to run out of postage stamps. You're going to run out of people to sell it to. And now you're left with a go down full of postage stamps that you can't sell to anyone. Right? So similar to the bindi wasted at the end of the day, there are postage stamps wasted at the end of the day. Right? Okay. which is how did he solve this problem? By the way, he got more and more people to invest and then took money from X to pay Y and then money from Y.
That is what is called a classic Ponzi scheme. We have done an episode on that. Check it out. That's not the point of this episode. So, we move on. But the general thing I want to point out is that if the prices of the same thing you have two different prices in two different places there is either overhead costs of if you buy from here and sell it here there is an overhead cost correct transaction costs or there is a risk right correct and the people who are buying at a higher price here are paying the higher price because they don't want to pay uh uh take that risk, right? Someone else is taking the risk
and that's why they're getting the money, right? So that is the main episode. In most cases, huh, if you see different prices, assume that there is risk or transaction costs that you are missing. Message one is that if you see same thing at two different prices in two different places assume that you are missing some transaction or costs or overheads or you're missing some risk right the risk could be in terms of spoilage it could be in terms of legal something it could be in terms of whatever right risk is there conversely or you know looking at it from a different angle if somebody is giving you something for much cheaper, right? Or buying something from you at
much higher rate than what otherwise would be. Right? Again, clearly there's an arbitrage opportunity there somehow. Yeah. And it is very likely that they are lying. Right? Example, if someone promises you 20% guaranteed return on investment per year, think of Charles Poni, right? Think well forget Charles Ponzi, right? There is a simple arbitrage opportunity here. You borrow from a bank at 8% and give it here for 20% and pocket the 12% difference. Right. Correct. And just I mean free money like this never exists which means that the person promising you 20%.
Is doing so at a higher risk. Either there is a full risk that this person won't be able to pay you back or there is some hidden charge that you are not aware of. Yeah. Right. So, and that should be your first and primary thought, not that oh my god, I'm getting free. Right. Hold on one sec. Uh there are several banks that are offering much higher absolutely same same concept, right? As in my well-known bank KO or HDFC or S I see I see they are offering let's say 8%.
more like but and the Nashik people's cooperative bank is offering 3% higher. We don't know if Nashik people's cooperative exists and if it no it does exist and it does offer higher. It did offer higher. My dad put money into it. My uncle put money into it because of the 3% extra. Clearly there is an arbitrage opportunity here. Someone somewhere could have just borrowed from here, put here and pocketed the difference and become very rich. But the reason that nobody important did that is because there was a higher risk with Nashik's right and sure enough one day Nashik people's was frozen by RBI and that money got stuck for years with people not being sure of whether
they're going to get their money back or not. Ultimately I think everyone got their money back but that was after it being stuck in limbo for many years until some other bank uh came and rescued Nashik people's back right this happens regularly if there is an arbitrage opportunity it means there is an overhead cost or transaction cost or some hidden cost that you don't know of or there is some risk this was the risk this was the risk yeah so much to think about in terms of arbitrage don't just go blindly to buy low and sell high. Think of what it actually means to buy low and what are the costs before you can sell high.
Yeah, all kinds of cost. A third kind of cost there could simply be opportunity cost, right? As in just to get that lower cost, you might have to travel somewhere and come back and what else could you be doing in that extra time that you wasted, right? So check out our episode on opportunity cost also. Very good. We ending with an episode reference which basically means that you get to see that episode next. Go ahead, enjoy that episode on opportunity costs. If it is already ready, we'll have a link in the description or it might be lined up for you next. Thank you so much for watching this episode. Shriant Naven Future IQ