What Is Arbitrage?

In order to convert the price or rate difference between the marketplaces into risk-free gains, arbitrage entails purchasing and selling two related assets in two different markets.

Main Points

• To take advantage of the price difference and generate risk-free gains, arbitrage entails simultaneously purchasing and selling two linked assets in different markets.
• The existence of market inefficiencies creates arbitrage opportunities.
• Locational, triangular, or covered interest arbitrage are examples of common types of arbitrage.
• The approach may not be appropriate for the typical individual investor because it frequently calls for more volume, quickness, and complex understanding.

Arbitrage: A Definition and Example

The goal of the trading method known as arbitrage is to profit from the difference between two markets by simultaneously buying and selling similar securities, currencies, or other assets in two different marketplaces at two different prices or rates.

For instance, the investor can turn the difference between the markets’ exchange rates into a risk-free profit if they are able to sell their investment for more than they paid for it after taking the exchange rate between the markets into consideration.

It helps to think about a straightforward illustration of the approach in order to comprehend how investors benefit from arbitrage.

Consider that you want to purchase shares of ABC Corp., which are now going for $40 each on the NYSE. You discover, before to purchasing the shares, that the same company is currently trading at $40.25 a share after accounting for exchange rates on the Euronext exchange (the stock market for the European Union).

You buy ABC shares on the NYSE and sell them simultaneously on the Euronext in order to take advantage of the arbitrage opportunity. You make $0.25 per share in profit. Despite the fact that it might not seem important, if you were to buy and sell 10,000 shares, you would generate $2,500 in profit from a single transaction.

How Arbitrage Works

There shouldn’t be any possibilities for arbitrage in an efficient market where stocks, bonds, currencies, and other assets are priced in accordance with their genuine worth. Sometimes, inefficient global markets result in price or rate discrepancies between markets. Through a process known as “arbitrage,” investors can and do profit from these inefficiencies.

Of course, there must be pricing differences across financial institutions for arbitrage to occur. These days, such price differences can disappear within a few milliseconds. Additionally, they’re typically negligible, so unless you have a sizeable sum to invest, it normally doesn’t make sense to try arbitrage tactics.

Note
So-called high-frequency traders, who are familiar with foreign currency markets and employ algorithms, extremely fast computers, and internet connections to scan markets and swiftly execute large volumes of orders, are more frequently the ones who engage in arbitrage.

Arbitrage types

Even though there are several arbitrage strategies, these three are the most common ones:

Locational

By engaging in this popular form of arbitrage, a trader might profit from a situation when one bank’s price to purchase (or “bid”) a certain currency is higher than another bank’s price to sell (or “ask”) that currency.

For the sake of illustration, let’s imagine that Bank A offers a $1.25 exchange rate between the euro and the dollar, meaning that you will need to pay $1.25 to obtain one euro.

The exchange rate at Bank B is $1. An investor can exchange one euro for $1.25 in dollars at Bank A, then transfer that money to Bank B to trade for one euro at a 1:1 rate. At a 1:1 conversion rate, this would be 1.25 euros, or $1.25 converted back to euros. As a result, an investor earned $0.25 per euro.

Triangular

A “triangular” arbitrage method combining three currencies and banks has been used by certain investors. You could, for instance, use slight variations in exchange rates to convert U.S. dollars into euros, then convert those into British pounds, and finally back into dollars.

Covered Interest

An investor can use a “forward contract” (an agreement to buy or sell an asset on a specific date in the future) to take advantage of an interest rate difference between two countries and reduce their exposure to fluctuations in exchange rates by using the covered interest-rate arbitrage trading strategy.

Let’s imagine, for illustration purposes, that the British pound has a greater 90-day interest rate than the American dollar. You might borrow dollars and then exchange them for pounds. Then, you would deposit that sum at the higher rate and simultaneously sign a 90-day forward contract that would convert the deposit back into dollars at a predetermined exchange rate when it matured.

You will profit when the forward contract is settled and the debt is eventually repaid in dollars.

Note
Buying and selling currencies is one of the most typical methods arbitrageurs generate income. Exchange rates and currencies are subject to change, which presents opportunities for investors to profit. Currency trading is a component of some of the most sophisticated arbitrage strategies.

Pros and Cons of Arbitrage

Although this tactic has advantages, it also has drawbacks:

Pros

Assurance of profits

no investment in capital

Cons

short-lived opportunity

potential changes in cost or interest rates

 

Pros Presented

The principal benefits of arbitrage are:

Earnings with no risk: Since the buying and selling prices are known in advance, profits from an arbitrage strategy that is properly executed can be seen as having no risk. Arbitrage doesn’t involve wagering on the future performance of a security, unlike traditional stock or bond trading, which involves purchasing a security now and selling it later.

No financial outlay: You don’t even need to put up your own money to profit from an arbitrage opportunity if you’re only capitalizing on pricing errors or inconsistencies (for instance, through locational arbitrage).

Cons Explanation

Arbitrage has several drawbacks, including:

Opportunity is fleeting because arbitrage changes supply and demand in such a way that prices eventually realign, reducing the likelihood of future arbitrage.

For instance, the more arbitrageurs who purchase a stock in USD and sell it in EUR, the more USD will increase and EUR will decrease. The difference between the two currencies will eventually disappear, negating any possibility of profit.

Note
Arbitrage really helps to maintain strong correlations in the pricing of stocks across different financial instruments and markets, especially when it comes to ETFs.

Potential changes in cost or rate, fees, and taxes: There is always a danger that you will execute a trade at a time when it won’t be lucrative because prices, exchange rates, and interest rates fluctuate frequently and quickly.

If you don’t or are unable to simultaneously buy and sell a security due to lack of expertise, experience, or high-speed technology infrastructure, the likelihood of this occurring rises. Transaction costs, which can reduce your overall profit, and taxes, including the potential for various tax regimes in other nations, are additional possible dangers.