What Is Arbitrage? Definition, Meaning, Example, and Costs

With foreign exchange investments, the strategy known as arbitrage lets traders lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency, across two different markets. This move lets traders capitalize on the differing prices for the same said asset across the two disparate regions represented on either side of the trade.

What Is Arbitrage?

Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign exchange where the equity's share price has not yet adjusted for the exchange rate, which is in a constant state of flux. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, positioning the trader to harvest gains from this differential. Although this may seem like a complicated transaction to the untrained eye, arbitrage trades are actually quite straightforward and are thus considered low-risk.

Example of Arbitrage

Consider the following arbitrage example: TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). On a given day, let's assume the stock trades for $63.50CAD on the TSX and for $47.00USD on the NYSE. Let's further assume the exchange rate of USD/CAD is $1.37, meaning that $1USD = $1.37CAD, where $47USD = $64.39CAD. Under this set of circumstances, a trader can purchase TD shares on the TSX for $63.50CAD and can simultaneously sell the same security on the NYSE for $47.00USD, which is the equivalent of $64.39CAD, ultimately yielding a profit of $0.89 per share ($64.39 - $63.50) for this transaction.

Beware of Transaction Costs

When contemplating arbitrage opportunities, it is essential to take transaction costs into consideration, because if costs are prohibitively high, they may threaten to neutralize the gains from those trades. Case in point: In the aforementioned scenario, if the trading fee per share exceeded $0.89, the total arbitrage return would nullify those profits.

The Bottom Line

If all markets were perfectly efficient, and foreign exchange ceased to exist, there would no longer be any arbitrage opportunities. But markets are seldom perfect, which gives arbitrage traders a wealth of opportunities to capitalize on pricing discrepancies.