What Is Arbitrage? Understanding Definition, Examples, and Costs


Arbitrage How Arbitraging Works in Investing, With Examples

What Is Arbitrage?

Arbitrage is a strategic financial maneuver employed by investors to exploit price differentials of a particular asset between two distinct markets.

This practice involves the simultaneous purchase and sale of the same security, commodity, or currency across these markets, with the aim of capitalizing on the temporary disparity in prices.

By leveraging this opportunity, traders can secure profits without bearing substantial risks traditionally associated with other forms of trading.

Key Takeaways

  • Arbitrage is the simultaneous purchase and sale of an asset in different markets to exploit tiny differences in their prices.
  • Arbitrage trades are made in stocks, commodities, and currencies.
  • By exploiting market inefficiencies, the act of arbitraging brings markets closer to efficiency.

How Does Arbitrage Work?

Arbitrage is trading that exploits the tiny differences in price between identical or similar assets in two or more markets.

The arbitrage trader buys the asset in one market and sells it in the other market at the same time to pocket the difference between the two prices.

There are more complicated variations in this scenario, but all depend on identifying market “inefficiencies.” Arbitrageurs, as arbitrage traders are called, usually work on behalf of large financial institutions.

It usually involves trading a substantial amount of money, and the split-second opportunities it offers can be identified and acted upon only with highly sophisticated software.

Example of Arbitrage

To illustrate, let’s consider a hypothetical scenario involving TD Bank (TD) listed on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE).

Assuming the stock is priced at $63.50 CAD on the TSX and $47.00 USD on the NYSE, with an exchange rate of $1.37 USD/CAD, a discerning trader can exploit this arbitrage opportunity.

By purchasing TD shares on the TSX and promptly selling them on the NYSE, the trader can capitalize on the price differential, thereby securing a profit per share equivalent to the price disparity adjusted for the exchange rate.

A More Complicated Arbitrage Example

A trickier example can be found in Forex or currency markets using triangular arbitrage. In this case, the trader converts one currency to another, converts that second currency to a third bank, and finally converts the third currency back to the original currency.

Suppose you have $1 million and you are provided with the following exchange rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.

With these exchange rates, there is an arbitrage opportunity: Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110

Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171

Sell pounds for dollars: £591,171 × 1.6939 = $1,001,384

Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384

From these transactions, you would receive an arbitrage profit of $1,384 (assuming no transaction costs or taxes).

Beware of Transaction Costs

While arbitrage presents lucrative profit potential, traders must exercise caution regarding transaction costs. High fees associated with executing trades can erode profits and diminish the viability of arbitrage strategies.

It’s imperative for investors to meticulously assess transaction expenses and ensure they do not outweigh the potential gains from arbitrage trades.

FAQs

Is Arbitrage Legal?

Yes, arbitrage is legal in the U.S. This trading practice contributes to market liquidity and efficiency by identifying and rectifying price disparities across different markets.

Can You Lose Money in Arbitrage?

Although arbitrage is generally considered low-risk, traders are not immune to potential losses. Factors such as execution risk, counterparty risk, and liquidity risk can impact arbitrage transactions, necessitating thorough risk management strategies.

What Makes Arbitrage Low-Risk?

Pure arbitrage, characterized by simultaneous buying and selling in different markets, is inherently low-risk. However, real-world arbitrage may involve additional complexities such as large-volume trades and leveraged capital, which can elevate risk levels.

Why Is Arbitrage Important?

In the course of making a profit, arbitrage traders enhance the efficiency of the financial markets. As they buy and sell, the price differences between identical or similar assets narrow.

The lower-priced assets are bid up, while the higher-priced assets are sold off. In this manner, arbitrage resolves inefficiencies in the market’s pricing and adds liquidity to the market.

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