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Arbitrage is a financial or economic strategy that involves exploiting price differences for the same asset, security, or commodity in different markets or locations. The goal of arbitrage is to make a risk-free profit by taking advantage of price disparities.
There are different types of arbitrage, such as risk, retail, convertible, negative, statistical, and triangular arbitrage. Each type has its own characteristics, advantages, and challenges. Some examples of arbitrage are:
- Buying shares on one exchange and then selling it for more money on another.
- Buying a currency pair on one exchange market and selling it at a premium on another.
- Purchasing a convertible bond while also selling the underlying shares and purchasing a put option in order to reduce risk.
- Based on a statistical relationship or model, buying an asset that is undervalued and selling an asset that is overvalued.
- Acquiring three triangle-shaped currency pairings and making use of the differences in conversion rates.
The foundation of arbitrage is the idea of an "invisible hand" that controls pricing in a free market. Arbitrageurs aid in lowering price discrepancies, boosting market effectiveness, and efficiently allocating resources by acting in their own self-interest. However, arbitrage also faces some limitations and costs, such as:
- Arbitrage is less profitable when there are market frictions such as transaction costs, taxes, laws, and liquidity restrictions.
- The pricing discrepancies are reduced and arbitrage opportunities are eliminated by market rivalries, such as other arbitrageurs or market makers.
- Market risks that raise an arbitrageur's vulnerability to losses or margin calls include volatility, unpredictability, and information asymmetry.
