Arbitrage

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalise upon the imbalance, the profit being the difference between the market prices.

Arbitrage is possible when one of three conditions is met:

  1. The same asset does not trade at the same price on all markets (“the law of one price”).
  2. Two assets with identical cash flows do not trade at the same price.
  3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate.

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete.

Example:

  • Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage.
  • If you can buy items at one price at a factory outlet and sell them for a higher price on an internet auction website such as eBay, you can exploit the imbalance between those two markets for those items.
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