Arbitrage refers to the simultaneous buying and selling of currency, commodities, securities or any type of financial instrument in different markets or derivative forms in order to exploit the differing prices for the same asset. The arbitrageur buys in one market and simultaneously sells in another where there is a marginal price differential. He or she profits from a temporary difference.
The term has nothing to do with arbitration – a non-judicial process for the settlement of disputes.
Usually it is a full hedge – a risk-free transaction. Arbitrageurs play a key role in maintaining liquidity and efficiency within markets.
BP (British Petroleum) shares sell both in the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). An Arbitrageur might buy BP shares low in LSE and at the same time sell them high in NYSE – that is an arbitrage trade.
Buying-selling done simultaneously
Arbitrage is a sophisticated form of risk-free, non-speculative betting because it involves transactions where prices and returns are guaranteed – fixed, definite and known.
Experts say that only in very exceptional situations, such as financial crises, can this type of activity be risky and lead to bankruptcy.
The term does not mean buying something in one market and selling it later in another for a greater price. The buying and selling must occur simultaneously to reduce market risk to a minimum.
If there is a time lapse between buying and selling, it is not arbitrage.
This simultaneous buying and selling is only practically possible with securities and other financial products that can be traded electronically.
Arbitrage – buy low and sell high
An arbitrage opportunity arises when you are able to instantaneously buy low and sell high.
A person who engages in this kind of trade is called an arbitrageur – he or she may be a banker or work in a brokerage firm.
Imagine somebody wants to sell a set of dinner plates for $20 in San Diego while in New York that same set sells for $40. If you are able to buy the plates in San Diego and sell them in the New York market, you can make a $20 profit with no risk, because the higher price for the plates in New York is guaranteed.
In financial markets, traders frequently try to take advantage of arbitrage opportunities. A trader may, for example, buy a stock on a foreign exchange where the price has not yet been adjusted for the fluctuating exchange rate. The stock on that foreign exchange is therefore undervalued compared to what it can fetch on the local market.
If the trader buys abroad and sells at home he or she will make a profit. In an arbitrage situation the buying and selling is done simultaneously.
Markets across the world are not 100% efficient, if they were there would be no arbitrageur, because there would be no opportunities. The trader needs to make sure he or she can make a profit after paying for transaction costs.
As in the case of the set of dinner plates bought in San Diego – if transporting them to New York costs $10, there is still a profit to be made, if it costs $21, the arbitrage opportunity has been erased.
According to BusinessDictionary.com, arbitrage is:
“Profiting from differences in prices or yields in different markets. ‘Arbitrageurs’ buy a commodity, currency, security or any other financial instrument in one place and immediately sell it at a higher price to a ready buyer at another place completing both ends of the transaction usually within a few seconds.”
Etymology of arbitrage
Etymologists (they study the origin of words) say that the word ‘arbitrage’ first appeared in the English language in the late fifteenth century, with the meaning ‘exercise of the function of an arbitrator’. It came from Old French arbitrage ‘judgment, arbitration’, which came from Old French aritrer ‘to judge, arbitrate’, which originated from Late Latin arbitrari and arbiter.
In the sense of a trader making a profit from price the differentials of the same product, it was first defined in 1704 by Mathieu de la Porte in his treatise ‘La science des négociants et teneurs de livres’ (Science Merchants and Bookkeepers) as a consideration of the differing exchange rates to recognize the most profitable places to issue and settle a bill of exchange.
He wrote ‘L’arbitrage est une combinaison que l’on fait de plusieurs changes, pour connoitre quelle place est plus avantageuse pour tirer et remettre”.
Video – What is an Arbitrage?
This Investors Trading Academy video explains in simple terms what an arbitrage is.