What Is Arbitrage?
Arbitrage is a financial strategy that seeks to exploit price discrepancies of identical or similar financial instruments across different markets or in various forms. It involves simultaneously buying and selling these instruments to benefit from the price differences.
Understanding Arbitrage
Arbitrage is based on the principle of market efficiency and the law of one price, which states that identical assets should have the same price across different markets. Traders use it to capitalize on market inefficiencies. It’s considered a low-risk strategy since the profit is realized almost instantaneously through simultaneous transactions.
Examples of Arbitrage
- Spatial: Buying a stock on one exchange where it’s undervalued and selling it on another where it’s priced higher.
- Triangular: Exploiting exchange rate discrepancies in currency markets by converting one currency into another, then a third currency, and finally back to the original currency.
A More Complicated Example
In the realm of Forex or currency trading, a more intricate form of arbitrage is triangular arbitrage. This strategy involves a series of currency exchanges. Initially, a trader converts one currency into a second currency, then that second currency into a third, and finally, the third currency back into the initial currency.
Consider an example where you start with $1 million and the following exchange rates are given: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.
An arbitrage opportunity arises with these rates:
- USD to EUR Conversion: Exchange $1 million for euros, which gives you €863,110 (calculated as $1 million ÷ 1.1586).
- EUR to GBP Conversion: Convert these €863,110 into British pounds, resulting in £591,171 (€863,110 ÷ 1.4600).
- GBP Back to USD: Finally, exchange these £591,171 back into US dollars, yielding $1,001,384 (calculated as £591,171 × 1.6939).
When you subtract your initial $1 million from the final amount of $1,001,384, you find an arbitrage profit of $1,384, assuming there are no transaction costs or taxes involved in these operations.
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.