What Is An Arbitrage Opportunity (& How You Can Make Money From It)?
We have published previously “4 ways an investor can make money on iGain IRS”. iGain IRS is Hakka Finance’s latest platform.
In several parts of the article, we mentioned the concept of arbitrage, without going into detail.
It sounds complicated, but it really isn’t actually.
So what is it?
Long story short: an arbitrage is a purchase and immediate sale of the same asset in different markets, to take advantage of a temporary price difference listed in those two markets. It is an opportunity for a trader to make a risk-free profit.
Arbitrage opportunities are usually a sign of slight market inefficiencies since information is not immediately simultaneously reflected everywhere.
Investors can take advantage of arbitrage opportunities by “hunting” them. It is common practice in foreign exchange (forex) markets to take advantage of currency fluctuations, in stock trading, or even commodities.
For instance, a “memecoin” can be bought right now at $99 in exchange A, and be sold at $100 in exchange B. That’s $1 of risk-free profit for an arbitrageur buying and selling immediately.
Also, traders taking advantage of arbitrage opportunities help make the market more efficient by closing the buy/sell gap.
- If they can buy at a lower price in market A, driving the listed price up,
- …and sell at a higher price in market B, driving the listed price down,
…they contribute to closing this gap. Hence, at the end of the day, the asset being traded is priced at fair.
In fact, DeFi can also be a fertile ground for arbitrage opportunities. And that includes iGain IRS.
How to take advantage of an arbitrage opportunity on iGain IRS
iGain IRS is a platform protecting investors against interest rate fluctuations on lending or yield-generating protocols like Aave or Yearn.
To be protected, traders have the choice of buying Long or Short tokens.
- ⬆️ If they think the interest rates on Aave/Yearn will go up for a specific stablecoin (more borrowers than lenders), they should buy LONG 🟢, the value of the tokens will increase with the rates.
- ⬇️ If they think they will go down for a specific stablecoin (more lenders than borrowers), they should buy SHORT 🔴, the value of the tokens will increase symmetrically to the decrease of rates.
Given that:
1LONG + 1SHORT = $1,
An increase of LONG value means a decrease of SHORT value, and vice-versa
Then, investors have 2 options:
- When the stablecoin term reaches maturity, users can redeem their tokens, and receive their compensation according to the rate fluctuations on Aave or Yearn.
- Users can sell their tokens before the end of the stablecoin term if they can already make a profit before.
Because the short-term value of LONG/SHORT tokens depends on the demand from iGain IRS users: if a lot of iGain users want SHORT tokens because they expect rates to go down, the price of SHORT will increase, regardless of what happens on Aave/Yearn.
As a consequence, iGain IRS rates are not perfectly correlated to Aave/Yearn rates. So, discrepancies will appear between:
- the actual value of LONG/SHORT (Mark Price)
and
- the redemption value at the end of the term (Index Price)
…giving room to arbitrage opportunities!
Example #1: Long Arbitrage opportunity
On the screenshot above, the current price of a LONG token (Mark Price -blue) is 0.87, and the redemption price (Index Price — green) will be 1.01.
The gap means there is an arbitrage opportunity since I can buy at 0.87 and redeem at 1.01 at maturity! That is at the condition that the Index Price remains the same on 2022–10–1.
Example #2: Short Arbitrage opportunity
Here’s a different situation, the price of LONG (0.23) is higher than the LONG redemption price (0.04). That means that the price of SHORT (1–0.23=0.77) is lower than the SHORT redemption price (1–0.04=0.96).
That means there is an arbitrage opportunity because I can buy SHORT at 0.77 and redeem it at 0.96!
That’s it!
To sum up, arbitrage opportunities on iGain can be spotted if there is a gap between Index and Mark Price, especially if we are approaching term maturity.
