What Is Arbitrage?
Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.
Arbitrage exists as a result of market inefficiencies, and it both exploits those inefficiencies and resolves them.
Key Takeaways
- Arbitrage is the simultaneous purchase and sale of an asset in different markets to exploit tiny differences in their prices.
- Arbitrage trades are made in stocks, commodities, and currencies.
- Arbitrage takes advantage of the inevitable inefficiencies in markets.
- By exploiting market inefficiencies, however, the act of arbitraging brings markets closer to efficiency.
Understanding Arbitrage
Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader.
Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds.
Examples of Arbitrage
As a straightforward example of arbitrage, consider the following: The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE), while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE).
A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share.
The trader can continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or the LSE adjust their prices to wipe out the opportunity.
Types of arbitrage include risk, retail, convertible, negative, statistical, and triangular, among others.
A More Complicated Arbitrage Example
A trickier example can be found in Forex or currency markets using triangular arbitrage. In this case, the trader converts one currency to another, converts that second currency to a third bank, and finally converts the third currency back to the original currency.
Suppose you have $1 million and you are provided with the following exchange rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.
With these exchange rates, there is an arbitrage opportunity:
- Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110
- Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171
- Sell pounds for dollars: £591,171 × 1.6939 = $1,001,384
- Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384
From these transactions, you would receive an arbitrage profit of $1,384 (assuming no transaction costs or taxes).
How Does Arbitrage Work?
Arbitrage is trading that exploits the tiny differences in price between identical or similar assets in two or more markets. The arbitrage trader buys the asset in one market and sells it in the other market at the same time to pocket the difference between the two prices. There are more complicated variations in this scenario, but all depend on identifying market “inefficiencies.”
Arbitrageurs, as arbitrage traders are called, usually work on behalf of large financial institutions. It usually involves trading a substantial amount of money, and the split-second opportunities it offers can be identified and acted upon only with highly sophisticated software.
What Are Some Examples of Arbitrage?
The standard definition of arbitrage involves buying and selling shares of stock, commodities, or currencies on multiple markets to profit from inevitable differences in their prices from minute to minute.
However, the term “arbitrage” is also sometimes used to describe other trading activities. Merger arbitrage, which involves buying shares in companies prior to an announced or expected merger, is one strategy that is popular among hedge fund investors.
Why Is Arbitrage Important?
In the course of making a profit, arbitrage traders enhance the efficiency of the financial markets. As they buy and sell, the price differences between identical or similar assets narrow. The lower-priced assets are bid up, while the higher-priced assets are sold off. In this manner, arbitrage resolves inefficiencies in the market’s pricing and adds liquidity to the market.
The Bottom Line
Arbitrage is a condition where you can simultaneously buy and sell the same or similar product or asset at different prices, resulting in a risk-free profit.
Economic theory states that arbitrage should not be able to occur because if markets are efficient, there would be no such opportunities to profit. However, in reality, markets can be inefficient and arbitrage can happen. When arbitrageurs identify and then correct such mispricings (by buying them low and selling them high), though, they work to move prices back in line with market efficiency. This means that any arbitrage opportunities that do occur are short-lived.
There are many different arbitrage strategies that exist, some involving complex interrelationships between different assets or securities.
Correction—April 9, 2022: A previous version of this article had miscalculated the complicated arbitrage example.
Arbitrage is a fascinating concept leveraging market inefficiencies for profit. It involves simultaneously buying and selling the same or similar assets across different markets to exploit slight price differences. Such opportunities stem from temporary pricing inconsistencies and are essential for market efficiency.
There are various types of arbitrage, including risk, retail, convertible, negative, statistical, and triangular arbitrage. Each method capitalizes on disparities in asset prices, but the essence remains consistent: buying low in one market and selling high in another.
The article delves into stock, commodity, and currency markets, illustrating how traders exploit pricing differences. For instance, it mentions a simple stock arbitrage scenario where Company X's shares are priced differently on the NYSE and the LSE, allowing traders to make a quick profit by buying low and selling high.
A more complex example involves triangular arbitrage in currency markets, where traders take advantage of exchange rate differences between three currencies to make a risk-free profit. This type of arbitrage involves multiple currency conversions to exploit the pricing discrepancies.
The piece also highlights the role of arbitrage in enhancing market efficiency. As arbitrageurs identify and act upon pricing discrepancies, markets tend to correct themselves, aligning prices and reducing inefficiencies. This process adds liquidity to the market and ensures that prices remain closer to fair value.
While economic theory suggests that markets should be efficient with no arbitrage opportunities, real-world scenarios prove otherwise. Markets often exhibit inefficiencies, providing windows for arbitrageurs to capitalize on price differentials.
Moreover, the article touches on various arbitrage strategies, including merger arbitrage, a tactic involving buying shares in anticipation of mergers, popular among hedge fund investors.
In essence, arbitrage is a critical mechanism that not only allows traders to profit from market discrepancies but also plays a role in correcting these inefficiencies, ultimately contributing to market efficiency and liquidity.
