Arbitrage is a short-lived technique that allows traders to explicit price variations which then again pushes the price to its normal limit. It means making profits by purchasing the same stocks in different markets which have a price difference. Arbitrage ensures that the value of the stock does not deviate from the fair value for a long period.
Arbitrage means making profits by purchasing the same stocks in different markets which have a price difference. This is a short-lived technique that allows traders to explicit price variations. Arbitrage is the result of the inefficiencies in the market and the inefficiencies are also the road to resolution since the traders trade extensively for price differences.
How to understand arbitrage?
Arbitrage is utilized when the commodity, stock and currency are bought in one market and sold in another market for a different price which gives the trader a risk-free trading opportunity. Arbitrage ensures that the value of the stock does not deviate from the fair value for a long period. Moreover, with the technological introductions, the profit in price error has also been significantly reduced. Hence, traders monitor fluctuations avidly with the help of financial instruments. If the pricing system is not effective, the opportunity is missed without being noticed.
For example, company A’s stock is being traded at $20 on (NYSE) New York Stock Exchange, while in London Stock Exchange, the same is trading for $20.05. To gain profits, the trader will buy them from the NYSE and sell them in the LSE and earn 5 cents for each share.
This arbitrage opportunity can continue to be exploited until Company A’s stock runs out from the inventory of NYSE or the prices are adjusted between the two stocks. The different types of arbitrage are negative, statistical, irregular, risk, retail and triangular etc.
Moreover, the people who benefit from this opportunity are called arbitrageurs and they usually operate in large financial institutions. These traders usually deal in substantial amounts and act on the opportunities in a split second with very advanced software.
A complex arbitrage example
In triangular arbitrage, the trader usually trades through a currency converter, where they convert the currency at the bank and then another currency at another bank, and the third currency into the original currency at yet another bank.
For example, you have $2 million. You assess that the exchange rates at the 3 banks are:
- USD/British pound: 1.432
- Euros/USD: 0.894
- Euros/British pound: 1.276
Hence, first, the 2 million dollars will be converted in euros at the bank at a 0.894 exchange rate, which will lead to 1,788,000 euros, then they will be converted to British pounds 1.276, which converts to 1,401,254 pounds. Then the said pounds will be converted to U.S. dollars at a 1.432 rate, which converts to $2.006.596. Here, the profit incurred would be $6,596.
Importance of arbitrage
Arbitrage leads to an increase in the efficiency of financial markets. Here, the trades are always made between the same kind of assets but in different markets. The assets at a low price are bid up and the high-priced assets are sold in the market. Hence, the inefficiencies are eliminated and add more liquidity in the market.
