What is Arbitrage?

Published by Thomas Herold in Economics, Investments, Trading

'Arbitrage' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Arbitrage refers to the practice of taking advantage of the price imbalances sometimes arising in two or even more markets. People who work in foreign money exchange run their whole businesses on this model. As an example, they look for tourists who require a rapid exchange of their cash for the local currency. Tourists agree to accept this local money for a lower amount than the actual market rate, and the money changer gets to keep the spread created by the higher rate that he charges them for the local currency. This spread that the different rates create becomes his profit.

Many different scenarios allow for investors or businessmen to become involved in the arbitrage practice. Sometimes, one market is not aware of the existence of the second market, or it simply can not access it. Arbitrageurs, persons who avail themselves of arbitrage, are also able to benefit from the different liquidities present in various markets.

Arbitrage is typically employed to discuss opportunities with investments and money rather than price imbalances for goods. Because of arbitrageurs operating in various markets whenever they spot opportunities, the prices found in the higher market will commonly drop while the prices in the lower market will usually rise so that they meet somewhere around the middle of the price difference. The phrase efficiency of the market then deals with the rate of speed at which these differing prices converge towards each other.

There are people who make arbitrage their livelihood. Working in arbitrage offers the possibilities of lucrative gains and profits. It does not come free of risk though. The greatest danger is that the prices may change rapidly between the varying markets. As an example, the spreads could rapidly fluctuate in only the tiny amount of time that is necessary for the two transactions to take place. In instances where these prices are moving quickly, arbitrageurs may not only find that they missed the chance to realize the profit between the differences in the prices, but that in fact they lost money on the deal.

Examples of arbitrage in the financial markets abound. Convertible arbitrage is working with convertible bonds to realize arbitrage. The bond can be converted into stock of the issuer of the bond. Sometimes, the amounts of shares that the bond will convert to are worth more than the price of the bond. In this case, an arbitrageur will be able to make a profit by purchasing the bond, converting it into the stock shares, and then selling the stock on the exchange to realize the difference.

Relative value arbitrage is using options to acquire the underlying shares of stock. It might be that the option is less expensive relative to the shares of stock that it will purchase. If a stock trades at $200, and the option that permits you to buy a share of the stock for $120 is trading at only $50, then you could buy the option, exercise it for the shares, and sell it for $200. You would only have spent $170 per share on the purchase, and then realize a $30 per share profit.

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The term 'Arbitrage' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.