Definition
Arbitrage is the instantaneous buying and selling of an asset in order to earn profit from a price difference and people involved in this process are called arbitrager.
This trade gives profit by taking advantage of differences in price of similar or identical instruments in different markets.
Explanation
Arbitration occurs when market inefficiencies exist. It is a trading strategy that makes profit without any risk or cost. Such kind of opportunities show discrepancies of minor pricing between related instrument or markets. It is also known as leveraged speculative transaction.
In terms of the stock market, traders usually try to exploit the opportunities of arbitrage. For instance, a trader purchased the stock of foreign exchange, where prices are not yet adjusted due to the continuous fluctuation of exchange rate.
In foreign exchange, the price of the stock is undervalued as compared to local exchange and the trader take advantage by making profits from the price difference. If the transaction cost is high, it can turn arbitrage opportunity into no benefit situation. On the other hand, if all markets are perfectly efficient, then there will not be any arbitrage opportunity, but the markets rarely remain perfect.
Arbitrage opportunity may occur if any of the following conditions is violated,
- The same security must trade at the same price in all markets.
- Two securities with identical cash flows must trade at the same price.
- A security with a known price in the future (via a futures contract) must trade today in
that price discounted by the risk-free rate.
