Arbitrage

3 key takeaways

• Arbitrage involves buying and selling an asset simultaneously in different markets to profit from price differences.
• It ensures market efficiency by aligning prices across different markets.
• There are various forms of arbitrage, including pure arbitrage, risk arbitrage, and statistical arbitrage.

What is arbitrage?

Arbitrage is a trading strategy that takes advantage of price differences of the same or similar financial instruments in different markets. By buying the asset at a lower price in one market and selling it at a higher price in another, traders can lock in a risk-free profit. Arbitrage opportunities are typically short-lived as market forces quickly adjust prices to eliminate discrepancies.

Importance of arbitrage

Arbitrage is crucial for maintaining market efficiency. By exploiting price differences, arbitrageurs help align prices across different markets, ensuring that assets are fairly valued. This activity reduces price disparities and contributes to liquidity and stability in financial markets. Arbitrage also plays a vital role in pricing derivative instruments and maintaining the integrity of financial markets.

How arbitrage works

Identifying discrepancies: The first step in arbitrage is identifying price differences for the same or similar assets in different markets. This requires monitoring multiple markets simultaneously and using advanced tools and algorithms for rapid detection.

Simultaneous transactions: Once a price discrepancy is identified, the arbitrageur buys the asset in the market where it is undervalued and sells it in the market where it is overvalued. These transactions are executed simultaneously to ensure the profit is locked in without exposure to market risk.

Profit realization: The difference between the purchase price and the selling price, minus any transaction costs, represents the arbitrage profit. Because these transactions are typically low-risk, the profit margins are often small, requiring large volumes or high-frequency trading to be significantly profitable.

Examples of arbitrage

• Currency arbitrage: A trader notices that the exchange rate for EUR/USD is different in the London market compared to the New York market. By simultaneously buying euros in London and selling them in New York, the trader profits from the exchange rate discrepancy.
• Stock arbitrage: Shares of a company are trading at $100 on the New York Stock Exchange (NYSE) and $101 on the London Stock Exchange (LSE). An arbitrageur buys the shares in New York and sells them in London, earning a $1 profit per share minus transaction costs.
• Commodity arbitrage: Gold is priced differently on two commodity exchanges. An arbitrageur buys gold futures on the cheaper exchange and sells them on the more expensive exchange, locking in a risk-free profit.

Real-world application

Consider a scenario where a technology stock is trading at $150 on the NASDAQ and $152 on the Tokyo Stock Exchange (TSE). An arbitrageur spots this price discrepancy and executes the following trades simultaneously:

• Buys 100 shares of the technology stock on the NASDAQ at $150 each.
• Sells 100 shares of the same stock on the TSE at $152 each.

The arbitrageur earns a profit of $2 per share, totaling $200, minus any transaction costs. This quick profit is achieved with minimal risk since the transactions are executed simultaneously.

Understanding arbitrage is essential for traders, investors, and financial professionals. It highlights the importance of market efficiency and provides insights into strategies that capitalize on price discrepancies across different markets.

Related topics you might want to learn about include market efficiency, high-frequency trading, and derivative pricing. These areas provide further insights into how markets operate and the strategies used to ensure fair pricing and liquidity.