Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets to profit from minute differences in the asset’s listed price. It leverages short-lived variations in the price of identical or similar financial instruments across different markets or forms.
Arbitrage exists due to market inefficiencies, and it both exploits and resolves these inefficiencies.
Key Takeaways
- Arbitrage involves the simultaneous purchase and sale of an asset in different markets to exploit tiny price discrepancies.
- It is employed in trading stocks, commodities, and currencies.
- Arbitrage takes advantage of inherent market inefficiencies, thereby gradually moving markets toward greater efficiency.
Understanding Arbitrage
Arbitrage can be utilized whenever a commodity, stock, or currency is obtainable in one market at a given price and can simultaneously be sold in another market at a higher price, creating a risk-free profit opportunity for traders.
With today’s technological advancements, profiting from market pricing errors has become exceedingly challenging. Automated trading systems monitors fluctuations in similar financial instruments: inefficient pricing setups are usually quickly corrected, often within seconds.
Examples of Arbitrage
Straightforward Arbitrage Example
Let’s consider a basic example: the stock of Company X trades at $20 on the New York Stock Exchange (NYSE) while at the same moment trades for $20.05 on the London Stock Exchange (LSE).
A trader can purchase the stock on the NYSE and promptly sell it on the LSE, earning a profit of $0.05 per share. This arbitrage opportunity continues until either exchange adjusts its price.
Complex Arbitrage Example: Triangular Arbitrage
In currency markets, a complex example can be observed using triangular arbitrage. The trader would convert one currency to another, the second currency to a third, and finally, the third back to the original currency.
Consider you have $1 million and the following exchange rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, USD/GBP = 1.6939.
- Sell USD for EUR: $1 million ÷ 1.1586 = €863,110
- Sell EUR for GBP: €863,110 ÷ 1.4600 = £591,171
- Sell GBP for USD: £591,171 × 1.6939 = $1,001,384
- Calculate profit: $1,001,384 - $1,000,000 = $1,384
Thus, a profit of $1,384 is realized (excluding transaction costs and taxes).
How Does Arbitrage Work?
Arbitrage exploits minor price disparities between identical or similar assets in multiple markets. An arbitrage trader buys an asset in one market and sells it in another simultaneously to pocket the difference.
Arbitrageurs almost always work for large financial institutions and leverage sophisticated trading software, given the substantial amount of money and infinitesimal opportunities at play.
Additional Arbitrage Examples
Standard arbitrage encompasses trading stocks, commodities, or currencies across markets to exploit price differences. Additionally, merger arbitrage, involving the acquisition of shares in companies ahead of an announced or anticipated merger, is a common strategy among hedge funds.
The Importance of Arbitrage
Arbitrage enhances the efficiency of financial markets. By engaging in arbitrage, traders help narrow price disparities, pushing lower-priced assets upward and higher-priced ones downward. Thus, arbitrage corrects mispricings and boosts market liquidity.
The Bottom Line
Arbitrage involves simultaneously buying and selling the same or similar asset at varying prices to secure a risk-free profit. Economic theory suggests efficient markets should prevent arbitrage. However, as inefficiencies persist, arbitrage opportunities do arise, albeit briefly.
Arbitrage encompasses numerous strategies, often with complex interrelations between varied assets or securities.
Note: Data correction as of April 9, 2022: The previous version miscalculated a complex arbitrage example.
Related Terms: Market Inefficiencies, Fair Value, Fluctuations, Financial Instruments, Triangular Arbitrage.
