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.
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.
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).
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.
Correction—April 9, 2022: A previous version of this article had miscalculated the complicated arbitrage example.