Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices. This is considered risk-free profit for the investor/trader.
In the context of the stock market, traders often try to exploit arbitrage opportunities. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange and the trader can make a profit from this difference.
Here is an example of an arbitrage opportunity. TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). Let's say TD is trading for CAD63.50 on the TSX and USD47.00 on the NYSE. The exchange rate of USD/CAD is 1.35, which means that 1 U.S. dollar = CAD1.37. Given this exchange rate, USD47 = CAD64.39. Clearly, there's an opportunity for arbitrage here as, given the exchange rate, TD is priced differently in both markets. A trader can purchase TD shares on the TSX for CAD63.50 and sell the same security on the NYSE for USD47.00 (the equivalent of CAD64.39), netting them CAD0.89 per share (64.39 - 63.50) for the transaction.
If all markets were perfectly efficient, there would never be any arbitrage opportunities — but markets seldom remain perfect. It is important to note that even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity (For more on market efficiency, check out our article "What is Market Efficiency?")
Transaction costs can turn a possible arbitrage situation into one that has no benefit to the investor. For instance, consider the scenario with TD Bank shares above. If the trading fees per share or in total costs more than the total arbitrage return, the arbitrage opportunity would be erased.