Definition and Example of Arbitrage
Arbitrage is a trading strategy whereby you simultaneously buy and sell similar securities, currencies, or other assets in two different markets at two different prices or rates to capitalize on the differential between the markets. Assuming the investor sells for more than the purchase price after accounting for the exchange rate between the markets, for example, they can leverage the mismatch between the markets into a risk-free profit.
To understand how investors make a profit using arbitrage, it helps to consider a simple example of the strategy.
Suppose you’re considering buying shares of ABC Corp., which is trading on the New York Stock Exchange (NYSE) at $40 per share. Before buying the shares, you notice that the same company is trading on the Euronext exchange (the stock market for the European Union) at $40.25 per share after accounting for the exchange rate.
To act on the arbitrage opportunity, you purchase ABC shares from the NYSE and sell them at the same time on the Euronext. You earn a profit of $0.25 per share. Although this might not seem significant, if you were to buy and sell 10,000 shares, you would make a profit of $2,500 in a single transaction.
How Arbitrage Works
In an efficient market where stocks, bonds, currencies, and other assets are priced according to their true values, there should be no arbitrage opportunities. Global markets are sometimes inefficient, giving rise to price or rate mismatches between markets. Investors can and do make money from these inefficiencies through a process known as "arbitrage."
Of course, arbitrage can’t happen unless there are pricing discrepancies between financial institutions. Nowadays, such price discrepancies can last a matter of milliseconds. In addition, they're usually minuscule, so it generally doesn’t make sense to attempt arbitrage strategies unless you have a sizable amount to invest.
Arbitrage is more often carried out by so-called high-frequency traders who have knowledge of foreign-exchange markets and use algorithms, ultra-fast computers, and internet connections to scan markets and execute high volumes of orders quickly.
Types of Arbitrage
Though there are many types of arbitrage, this trading strategy typically takes one of three main forms:
Through this common type of arbitrage, an investor can capitalize on a scenario in which one bank's buying (or "bid") price for a given currency is higher than another bank's selling (or "ask") price for that currency. By way of illustration, let’s assume that the exchange rate at Bank A between the euro and U.S. dollar is $1.25; in other words, you'll have to spend $1.25 to get one euro. Bank B has the exchange rate at $1. An investor can take one euro and convert it into dollars at Bank A (getting $1.25), then take that money to Bank B and convert it back to euros at the 1:1 exchange rate. This would mean $1.25 converted back to euros at the 1:1 exchange rate, or 1.25 euros. Thus, an investor made a profit of $0.25 per euro.
Some investors have been known to deploy a “triangular” arbitrage strategy involving three currencies and banks. For example, you could exchange U.S. dollars for euros, then euros into British pounds, then British pounds back into dollars, taking advantage of small discrepancies in currency exchange rates along the way.
Covered interest-rate arbitrage is a trading strategy in which an investor can utilize a “forward contract” (an agreement to buy or sell an asset on a certain date in the future) to capitalize on an interest rate discrepancy between two countries and eliminate their exposure to changes in exchange rates. For example, let's say that the 90-day interest rate for the British pound is higher than that for the U.S. dollar. You might borrow money in dollars and convert it into pounds. You would then deposit that amount at the higher rate, and at the same time enter into a 90-day forward contract where the deposit would be converted back into dollars at a set exchange rate when it matures. When you settle the forward contract and later repay the loan in dollars, you'll make a profit.
One of the most common ways people make money through arbitrage is from buying and selling currencies. Currencies can fluctuate, and exchange rates can move along with them, creating opportunities for investors to exploit. Some of the most complex arbitrage techniques involve currency trading.
Pros and Cons of Arbitrage
This strategy can be a money-maker but also has downsides:
No capital investment
Potential price or rate fluctuations
The key advantages of arbitrage are:
- Risk-free profits: The profits derived from arbitrage executed correctly can be considered risk-free, because the buying and selling price are known in advance. In contrast to trading stocks or bonds through a traditional strategy of buying a security now and selling it at some point in the future, arbitrage doesn’t require betting on the future performance of a security.
- No capital investment: If you're merely capitalizing on pricing mistakes or discrepancies (for example, through locational arbitrage), you don't even have to invest capital of your own to take advantage of an arbitrage opportunity.
The drawbacks of arbitrage include:
- Fleeting opportunity: Arbitrage affects supply and demand in such a way that prices eventually realign, diminishing the opportunity for arbitrage in the future. For example, the more arbitrageurs who buy a stock in U.S. dollars and sell it in euros, the more the U.S. dollar will rise and the euro will fall. This will have the effect of decreasing the disparity between the two currencies until there is none, and no profit can be made.
When it comes to ETFs in particular, arbitrage actually plays an important role in keeping the pricing of securities tightly correlated between various financial instruments and markets.
- Potential price or rate fluctuations, fees, and taxes: Prices and exchange or interest rates change frequently and rapidly, so there’s always a chance that you may execute a trade at a time when it may not be profitable. The odds of this happening increase if you don't or can't simultaneously buy and sell a security because you don't have the knowledge, experience, or high-speed technology infrastructure to do so. Other potential risks include transaction fees, which can cut into your overall profit, and taxes, including the possibility of different tax treatments in foreign countries.
- Arbitrage involves buying and selling two related assets at the same time in different markets to extract risk-free returns from the price differential.
- Inefficiencies in the global market give rise to opportunities for arbitrage.
- Common types of arbitrage include locational, triangular, or covered interest arbitrage.
- The strategy often requires more speed, volume, and complex knowledge and may not be suitable for the average individual investor.