Arbitrage
Arbitrage is a financial strategy employed by traders to achieve risk-free profit by exploiting temporary price discrepancies of identical or similar assets across different markets. This practice hinges on the principle of buying an asset at a lower price in one market and selling it at a higher price in another, thereby capitalizing on the differences. Historically, arbitrage has been utilized for centuries, dating back to the trading of commodities, and evolved with the introduction of financial instruments like bills of exchange during the Middle Ages.
In modern contexts, arbitrage can also involve discrepancies between a security's spot price and its future contract values. Despite advancements in electronic trading that have improved market efficiency, the theory of perfectly efficient markets remains largely unachieved, allowing arbitrage opportunities to persist, albeit less frequently. The economic law of one price suggests that identical assets should have the same value, but temporary market inefficiencies can create opportunities for traders to profit. However, it is important for traders to account for transaction costs, as these can diminish potential profits from arbitrage trades. This makes the understanding of market dynamics and timing essential for successful arbitrage.
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Arbitrage
In finance and investing, arbitrage is a technique traders use to make a risk-free, guaranteed profit by taking advantage of slight, temporary differences in the market prices of a security or an asset. Arbitrage requires that functionally identical securities or assets be listed on multiple exchanges with price discrepancies between the listings. Traders then purchase the financial instrument at the lower price, and then immediately sell it at the higher price and keep the difference.
Alternately, arbitrage traders can profit on similar discrepancies between the spot price of a security and the exchange-traded value of the security's future contract. Spot price is a financial term referring to the price at which an asset could be immediately purchased. A future contract is a type of agreement between a buyer and a seller, in which the buyer commits to a speculative future price for the asset and the seller agrees to furnish the asset on the specified date at that price.
Brief History
Arbitrage strategies have been used to secure profits in the trading of goods and commodities for centuries. In ancient times, arbitrage strategies largely revolved around commodities being secured at a lower price at their point of origin, where they were in plentiful supply, and then sold for a higher price after being imported to a different region, where they were in scarcer supply. At this time, successful arbitrage-based trades generally relied on goods traveling across long distances from seller to buyer. Traders seeking to profit in this way faced significant risks, as it was possible for the goods to be lost, damaged, or stolen while in transit.
During the Middle Ages, a financial instrument known as a bill of exchange came into common use and created new opportunities for arbitrage transactions. A bill of exchange is a written order used for the exchange of goods, in which the buyer agrees to pay the seller a fixed sum of money at a specified future date. As they were used in the Middle Ages, bills of exchange could be used to create profits if the buyer was able to resell the acquired goods to another party at a higher price before paying the seller the agreed-upon sum. By definition, bills of exchange do not bear interest, which enabled the arbitrage traders of the period to achieve a necessary measure of cost certainty.
Arbitrage immediately emerged as a profitable trading strategy with the development of formal financial markets. During the seventeenth century, the strategy was usually used to secure profits in the market-based trading of gold and bills of exchange, which had become tradable financial instruments in their own right by that point. As financial markets continued to evolve into their modern form during the eighteenth and nineteenth centuries, the modern notion of risk-free arbitrage began to appear. The strategy came to be applied to commodities as well as to exchange-traded securities, such as stocks and bonds. Market inefficiencies were more common prior to the rise of electronic trading and near-instant communication, which made arbitrage opportunities more common in the nineteenth and early twentieth centuries than they are in the twenty-first century.
Overview
During the late twentieth and early twenty-first centuries, electronic and Internet-based trading platforms greatly improved market efficiency. However, the notion of a perfectly efficient global market continues to exist only in theory, and while arbitrage opportunities are less common than they once were, they remain available, and traders still look to exploit them when they arise.
According to the economic law of one price theory, near-identical or identical assets with identical risk profiles should always carry the same value, or offer the same rate of return. If any differences in the values of two such securities existed, the discrepancy would be immediately corrected by market forces. Suppose, for example, that two identical assets were available at different prices. In theory, traders holding the asset could immediately profit by selling it for its higher value, and then using the funds they obtained to rebuy it at its lower value. However, in actual practice, such a situation would immediately cause the price of the higher-valued asset to be bid down, since more of the asset would be available for sale. Meanwhile, the price of the lower-valued security would be bid up, since demand for it would increase. Thus, the price discrepancy would be functionally eliminated.
Arbitrage circumvents the law of one price theory by capitalizing on temporary differences in the values of nearly identical or identical assets in two or more markets. For instance, consider a stock, Company X, that is sold on exchanges in both the United States and Canada. The value of Company X stock is denominated in US dollars on the American exchange, while it is denominated in Canadian dollars on the Canadian exchange. The exchange rates between the US and Canadian dollars are in a constant state of flux, and as such, the Company X share price must be constantly adjusted to reflect fluctuations in the respective currency denominations used in the two markets. If the share price of Company X as sold on the Canadian market has not yet been updated to account for an accompanying shift in the exchange rate between the Canadian and US dollars, an arbitrage opportunity has just opened up. Stock in Company X could be immediately bought and sold before the share price is adjusted to account for the shift in the exchange rate, allowing the trader to generate an immediate risk-free profit by capitalizing on the temporary difference in value that appeared before the share price on the Canadian exchange was corrected.
The delay in the share price correction to account for the shifting exchange rate between the two currencies is an example of a market inefficiency. If no market inefficiencies existed, then no arbitrage opportunities would exist. However, perfect market efficiency has not yet been achieved, and as such, arbitrage opportunities continue to be available. Yet, traders must carefully consider transaction costs when evaluating possible arbitrage opportunities. In some cases, the fees involved with buying and selling assets or securities can neutralize the potential to profit from an arbitrage trade.
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