Arbitrage opportunities exist when the prices of similar assets are set at different levels. This opportunity allows an investor to achieve a profit with zero risk and limited funds by simply selling the asset in the overpriced market and simultaneously buying it in the cheaper market.
This buying and selling of the asset will push the cheaper asset's price up and the higher asset price down. This process will continue until the asset price is equal in both markets.
Achieving this equilibrium through buying and selling is referred to as the law of one price. This law may look like it has been violated at times, but this usually is usually not the case once you factor in financing or delivery costs associated with the different markets.
- For example, on exchange A IBN is trading at $25 and on exchange B IBN is trading at $30 dollars. If you buy IBN on exchange A and simultaneously sell it on exchange B, you can net a profit of $5 with out any risk or any outlay of cash.
- As people continue to buy on exchange A, the price of IBN will increase and all of the selling of IBN on exchange B will force the price down until equilibrium has been reached. This is how arbitrage works to make the marketplace efficient.
Additional information about arbitrage and its theories:
- Theoretically, the large number of market participants combined with real-time price-setting mechanisms eliminates the opportunity to generate risk-free profits.
- This leads to an important question: If there are no arbitrage opportunities (i.e. opportunities to earn a risk-free profit), why does the industry survive? One reason is that individual investors may have different views on how, why and to what degree market prices are off kilter. Also, investors are reluctant to believe that there are no arbitrage opportunities and so they spend a good deal of time watching price movements, ferreting out inconsistencies and trading on those they perceive to exist. The process itself ensures that any potential arbitrage opportunities will be quickly discovered and eliminated. If investors believed there were no arbitrage opportunities and were no longer vigilant about identifying and exploiting price differentials, the lack of continuous oversight might, in itself, lead to arbitrage opportunities In other words, disbelief concerning the absence of arbitrage opportunities is required to maintain its legitimacy as a principle.
- Relatively efficient markets have either no arbitrage opportunities or the market participants quickly remove them. The opportunity can occur, but only through chance and it would be considered an abnormal return
Forward Markets and Contracts: Settlement Procedures
InvestingLearn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
TradingCovered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
TradingInvestors use the arbitrage pricing theory to identify an asset that’s incorrectly priced.
InvestingWhile the opportunities are few and far between, investors may use arbitrage to take advantage of price differences in financial spread betting.
TradingRisk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
InvestingThis influential strategy capitalizes on the relationship between price and liquidity.
InvestingGet details on three of the most popular mutual funds for investors interested in arbitrage trading.
TradingNot only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
InsightsChanges in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.