Arbitrage

Definition

Arbitrage is a financial strategy in which an investor exploits the price differences between multiple markets for identical or similar financial instruments, with the objective to earn a profit. It involves buying in a lower-priced market and simultaneously selling in a higher-priced market. The profit is the difference between the two market prices.

Phonetic

The phonetics for the word “Arbitrage” is /ˈɑːrbɪtrɑːʒ/ .

Key Takeaways

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1. Arbitrage is a financial strategy where an investor capitalizes on price differences in different markets for the same asset. It involves the simultaneous buying and selling of securities, currencies, or commodities to make a profit from the discrepancy.
2. Arbitrage presents a risk-free profit opportunity, as the transactions are done instantaneously to capitalize on the price difference. It is often employed through high-speed algorithms in modern financial markets.
3. The existence of arbitrage opportunities in a market indicates inefficiencies. In an ideal efficient market, there would be no such opportunities. But as arbitrage traders take advantage of these inefficiencies, they help bring the prices in different markets closer together, thereby making the market more efficient.

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Importance

Arbitrage is a significant concept in the field of finance and business as it promotes efficiency and equilibrium in the market. It is a strategy of buying an asset at a lower price in one market and simultaneously selling it at a higher price in another market, thus capitalizing on price discrepancies for a risk-free profit. These price differences could be due to factors like variations in supply and demand, trading volumes, or market inefficiencies. By exploiting these disparities, arbitrageurs contribute to market efficiency as their transactions balance prices across different markets. Therefore, the existence or possibility of arbitrage plays a crucial role in enforcing the law of one price, improving market liquidity, and contributing to the fairness and transparency of financial markets.

Explanation

Arbitrage serves as a key mechanism in keeping financial markets efficient, fair, and fluid. It is used by investors to take advantage of price discrepancies between different markets. The primary purpose is to buy an asset at a lower price in one market, then sell it at a higher price in another market to gain a profit. As this process is replicated by multiple arbitrageurs, the prices in the different markets will eventually converge, mitigating the price discrepancy. This ensures pricing efficiency across various markets, thereby preventing undue advantages to any particular group of traders.In the broader spectrum of the finance and business world, arbitrage aids in maintaining market stability. Additionally, it helps in the proper distribution of assets and their corresponding risks. This trading strategy is often employed by hedge funds, proprietary trading desks of investment banks, and individual traders with significant computing power and algorithmic trading capabilities. Without arbitrage, markets would be more prone to inefficiencies, which could lead to distortions in asset valuation and financial instability.

Examples

1. Currency Markets: This is perhaps the most common form of arbitrage. For example, if the exchange rates in London are £0.5 = $1 and in New York it is £0.6 = $1, an arbitrager might buy a large amount of the British currency in London and sell it in New York, making a profit with zero risk.2. Retail and Online Marketplaces: Another classic example of arbitrage occurs in the retail sector. Let’s say a trader finds a toy selling for $5 in a thrift store and the exact same toy is selling for $15 on an online website like eBay. The trader buys the toy in the thrift store and sells it on eBay, generating a profit. This is also called retail arbitrage.3. Stock Markets: Arbitrage often happens in stock markets. If a stock of company X is trading for $20 per share on the New York Stock Exchange (NYSE), but it’s available for $19.50 per share on the London Stock Exchange (LSE), an arbitrager would buy shares on the LSE and sell them at a higher price on the NYSE for a risk-free profit. This type of arbitrage is often carried out by computer algorithms within fractions of a second, and is typically only possible for large financial institutions with sophisticated technology.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Spot-Future Arbitrage
• Risk Arbitrage
• Arbitrage Pricing Theory (APT)
• Convertible Arbitrage
• Statistical Arbitrage

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Economist
• NASDAQ