Derivatives - Arbitrage

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
Related Articles
  1. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  6. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
Trading Center