• QA 040
    What is "arbitrage" between the Brazilian and New York futures markets?
    We read in market reports that the trade practices "arbitrage" between the Sao Paulo and the New York Exchanges but do not know what this is in fact, nor how this might be a factor in the market. If it is a factor, why and for who?
    Asked by:
    Co-operative - Ethiopia

    Put in its simplest form, arbitrage is the forecasting of the future price difference between different but related trading positions on futures exchanges. For example, if a trader feels that the price difference between two delivery positions on a futures exchange is too high or too low, then he will simultaneously buy the one and sell the other according to his conviction, speculating that the difference or 'spread' between the two will move in his favour. This type of speculative trading is quite widespread but is usually called "spread trading" rather than arbitrage. 

    A clearer example of arbitrage is between the New York (arabica) and London (robusta) exchanges because the price differences are much greater. In this case the trader, the arbitrageur, will speculate that the price difference between two comparable delivery positions in New York and London is over- or under-stated, and may move in his favour. So he will buy (or sell) New York arabica and sell (or buy) London robusta.

    The Brazilian exchange (BM&F - Bolsa de Mercadorias & Futuros in Sao Paulo) offers buyers of Brazilian arabica the opportunity to hedge their green coffee purchases without incurring the differential risk (see 09.01.03) that hedging them against the New York exchange involves. This because Brazilian arabica is presently not tenderable in New York. The arbitrageur will evaluate the price difference between two comparable delivery positions in Sao Paulo and New York and, based on his judgement, will buy the one and sell the other, again speculating that the difference will move in his favour.

    In all three examples the pure arbitrageur will always reverse purchases and sales by buying/selling the equivalent contracts and offsetting them, thus never taking delivery of any coffee because arbitrage really is a speculative activity.

    But pure arbitrage between the Sao Paulo and New York exchanges is an important market factor in the sense that high levels of arbitrage activity suggest that the trade generally expects a narrowing or widening of the price difference between Sao Paulo and New York. This is of interest also to exporters of Brazilian type coffees elsewhere in the world and therefore worth monitoring. Some roasters base purchasing decisions re what type of beans they are going to utilise on fluctuations in the arbitrage or price difference between each market, something that over time helps keep markets in tandem.

    Note though that unit prices are different in New York, Sao Paulo and London, making it necessary to convert one unit to another to arrive at the real difference or 'arbitrage'.

    * New York:  US cents per pound;
    * Sao Paulo:   US dollars per 60-kilo bag;
    * London:       US dollars per 1,000 kilos;

    For more on hedging and speculative operations generally see chapter 09. For more on BM&F itself see section 08.07.

    Posted 01 September 2005

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