What is 'Arbitrage'

Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.

BREAKING DOWN 'Arbitrage'

Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader. Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.

To understand more about this concept and different types of arbitrage, read Trading the Odds With Arbitrage.

A Simple Arbitrage Example

As a simple example of arbitrage, consider the following. The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE) while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share. The trader could continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X's stock, or until the specialists on the NYSE or LSE adjust their prices to wipe out the opportunity.

A Complicated Arbitrage Example

Though this is not the most complicated arbitrage strategy in use, this example of triangular arbitrage is more complex than the above example. In triangular arbitrage, a trader converts one currency to another at one bank, converts that second currency to another at a second bank, and finally converts the third currency back to the original at a third bank. The same bank would have the information efficiency to ensure all of its currency rates were aligned, requiring the use of different financial institutions for this strategy.

For example, assume you begin with $2 million. You see that at three different institutions the following currency exchange rates are immediately available:

  • Institution 1: Euros/USD = 0.894
  • Institution 2: Euros/British pound = 1.276
  • Institution 3: USD/British pound = 1.432

First, you would convert the $2 million to euros at the 0.894 rate, giving you 1,788,000 euros. Next, you would take the 1,788,000 euros and convert them to pounds at the 1.276 rate, giving you 1,401,254 pounds. Next, you would take the pounds and convert them back to U.S. dollars at the 1.432 rate, giving you $2,006,596. Your total risk-free arbitrage profit would be $6,596.

RELATED TERMS
  1. Currency Arbitrage

    Currency arbitrage is the act of buying and selling currencies ...
  2. Fixed-Income Arbitrage

    Fixed-income arbitrage is an investment strategy that realizes ...
  3. Index Arbitrage

    Index arbitrage is a trading strategy that attempts to profit ...
  4. Triangular Arbitrage

    Triangular arbitrage involves the exchange of a currency for ...
  5. Time Arbitrage

    Time arbitrage refers to an opportunity created when a stock ...
  6. Uncovered Interest Arbitrage

    Uncovered interest arbitrage involves switching from a a lower ...
Related Articles
  1. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing

    How Statistical Arbitrage Can Lead to Big Profits

    Statistical arbitrage is one of the most influential trading strategies ever devised. Learn how it is leveraged by investors and traders seeking profits.
  3. Insights

    Interest Rate Arbitrage Strategy: How It Works

    Changes in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.
  4. Investing

    Conversion Arbitrage

    This stock/options combination helps traders take advantage of market mispricing. Find out how.
  5. Insights

    How Does Arbitrage Betting Work?

    Arbitrage betting is a method or system for exploiting differences in odds for profit.
  6. Investing

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? Find out how this model estimates the expected returns of a well-diversified portfolio.
  7. Personal Finance

    What Are the Risks of Credit Card Arbitrage?

    Find out why credit card arbitrage is a major gamble with devastating risks for those trying to beat the credit card companies at their own rate game.
  8. Small Business

    How To Profit From Mergers And Acquisitions Through Arbitrage

    Making a windfall from a stock that attracts a takeover bid is an alluring proposition. But be warned – benefiting from m&a is easier said than done.
RELATED FAQS
  1. How do I use software to make arbitrage trades?

    Understand the meaning of arbitrage trading, and find out how traders leverage software programs to detect arbitrage trade ... Read Answer >>
  2. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
  3. How fair value is calculated in futures market?

    Learn how the fair value for futures stock index contracts is calculated, and understand how differences between those numbers ... Read Answer >>
Trading Center