Arbitrage is the exploitation of price discrepancies within different markets of similar or identical assets in order to generate low-risk to no-risk profits, after accounting for transaction and information costs. Arbitrage trading is not only legal in the United States, but is encouraged, as it contributes to market efficiency. Furthermore, arbitrageurs also serve a useful purpose by acting as intermediaries, providing liquidity in different markets.
Arbitrage and Market Efficiency
By attempting to benefit from price discrepancies, traders who engage in arbitrage are contributing towards market efficiency. A classic example of arbitrage would be an asset that trades in two different markets at different prices; a clear violation of the Law of One Price.
A trader can profit from this mispricing by buying the asset at the market that offers the lower price and selling it back on the market that buys at the higher price. Such profits, after accounting for transaction costs, will no doubt draw additional traders who will seek to exploit the same price discrepancy, and consequently, the arbitrage opportunity will disappear as the prices of the asset balances out across the markets. In terms of international finance, this convergence will lead to purchasing power parity between different currencies.
For example, if the same type of asset is cheaper in the United States than it is in Canada, Canadians would travel over the border to purchase the asset, while Americans would purchase the asset, bring it to Canada and resell it in the Canadian market.
In order to facilitate the transactions, Canadians would have to purchase U.S. dollars (USD), while selling Canadian dollars (CAD) in order to buy the asset in the U.S., and Americans would have to sell the CAD that they received from their sales of the asset in Canada to purchase USD to spend in America. These actions will lead to the appreciation of the American dollar and the depreciation of the Canadian currency in relation. Thus, over time, the advantage of purchasing this asset in the United States will dissipate until the prices converge.
Another example of arbitrage leading to price convergence can be observed in the futures markets. Futures arbitrageurs seek to exploit the price difference between a futures contract and the underlying asset and require a simultaneous position in both asset classes.
In a nutshell, if the futures contract is priced significantly higher than the underlying, after accounting for the cost-of-carry and interest rates, the arbitrageur can go long on the underlying asset while simultaneously shorting the futures contract. The arbitrageur would borrow the funds to purchase the underlying at the spot price and sell short the futures contract. After storing the underlying, the arbitrageur can deliver the asset at the future price, repay the borrowed funds, and profit from the net difference.
Whenever the rate of return from this transaction exceeds the cost to borrow the asset, as well as the cost of storing the asset, there can be an arbitrage opportunity.
As you can imagine, each time a price discrepancy appears between a futures contract and its underlying, traders will enter into one of the aforementioned trades before the inefficiency grows rampant. As more and more traders attempt to make arbitrage profits, the price of the futures contract will be driven down (up) and the underlying will be driven up (down). Both cases contribute to the fair and efficient pricing of the futures markets.
Arbitrageurs as Market Makers
When arbitrageurs buy and sell the same asset in different markets, they are in effect, acting as financial intermediaries, and therefore, providing liquidity to the markets.
For instance, the options trader who writes call options when they feel that they are overpriced may hedge their position by going long stock. In doing so, they are acting as an intermediary between the options and the stock market. That is, they are buying stock from a stock seller while simultaneously selling an option to an option buyer and contributing to the overall liquidity of the two markets. Similarly, the futures arbitrageur would be an intermediary between the futures market and the market of the underlying asset.
The Bottom Line
There are a plethora of arbitrage techniques that can be executed whenever there is perceived market inefficiency. However, as more and more arbitrageurs attempt to replicate these no-risk or low-risk events, these opportunities disappear, leading to a convergence of prices. For this reason, arbitrage is not only legal in the United States (and most developed countries), but also beneficial to the markets as a whole and conducive towards overall market efficiency.