What is Arbitrage?

arbitrageArbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price.

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

When used by academics, an arbitrage is a (imagined, hypothetical, thought experiment) transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.

It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.

Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader. Arbitrage provides a mechanism to ensure 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 often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.

A Simple Arbitrage Example

As a simple 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 could 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 LSE adjust their prices to wipe out the opportunity.

A Complicated Arbitrage Example

Though this is not the most complicated arbitrage strategy in use, this example of triangular arbitrage is more complex than the above example. In triangular arbitrage, a trader converts one currency to another at one bank, converts that second currency to another at a second bank, and finally converts the third currency back to the original at a third bank. The same bank would have the information efficiency to ensure all of its currency rates were aligned, requiring the use of different financial institutions for this strategy.

For example, assume you begin with $2 million. You see that at three different institutions the following currency exchange rates are immediately available:

– Institution 1: Euros / USD = 0.894
– Institution 2: Euros / British pound = 1.276
– Institution 3: USD / British pound = 1.432

First, you would convert the $2 million to euros at the 0.894 rate, giving you 1,788,000 euros. Next, you would take the 1,788,000 euros and convert them to pounds at the 1.276 rate, giving you 1,401,254 pounds. Next, you would take the pounds and convert them back to U.S. dollars at the 1.432 rate, giving you $2,006,596. Your total risk-free arbitrage profit would be $6,596.

Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:

– The same asset does not trade at the same price on all markets (“the law of one price”).
– Two assets with identical cash flows do not trade at the same price.
– An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset has significant costs of storage; as such, for example, this condition holds for grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally possible only with securities and financial products that can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called execution risk or more specifically leg risk.

In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. “True” arbitrage requires that there is no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.

Summary

If all markets were perfectly efficient, there would never be any arbitrage opportunities—but markets seldom remain perfect. Transaction costs can turn a possible arbitrage situation into one that has no benefit to the investor.

 


 

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