What Is Arbitrage?
It plays an important role, especially when it comes to ETFs
Economics or investing experts often refer to markets as being “inefficient.” They’re not referring to the speed of trades--but rather, the idea that stocks, bonds, currencies, and other assets are not always priced according to their true value.
Investors can and do make money from these inefficiencies, through a process known as arbitrage. Arbitrage may require too much speed, volume, and complex knowledge for the average individual investor, though.
Nevertheless, especially when it comes to ETFs, arbitrage actually plays an important role in keeping the pricing of securities tightly correlated between various financial instruments and markets.
How Arbitrage Works
To understand how investors make a profit using arbitrage, it helps to consider a simple example of arbitrage.
Let’s say you’re considering buying shares of XYZ Corp., which is trading on the New York Stock Exchange 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.
If you wanted to engage in arbitrage, you would purchase XYZ shares from the NYSE and sell them at the same time on the Euronext. That would earn you a profit of 25 cents per share. While this might not seem significant, if you were buying and selling 10,000 shares, you would make $2500 in a single transaction.
Arbitrage in Today’s Markets
Arbitrage can’t happen unless there are pricing discrepancies between financial institutions. In the past, these discrepancies were common, and average investors could take advantage of them because information didn’t flow as fast.
Nowadays, price discrepancies can last a matter of milliseconds. In addition, the price discrepancies are usually very small, so it generally doesn’t make sense to attempt arbitrage strategies unless you have a sizable amount to invest.
Because of this, arbitrage has been increasingly carried out by so-called “high-frequency traders” who use algorithms and ultra-fast computers and internet connections to scan markets and execute very high volumes of orders quickly.
Arbitrage and Currencies
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.
By way of illustration, let’s assume that the exchange rate at Bank B between the euro and U.S. dollar is $1.25. This means that you will have to spend $1.25 to get one euro.
Meanwhile, Bank B has the exchange rate even at $1.
An investor can take one euro and convert it into dollars through Bank A (getting $1.25), then taking that money to Bank B and converting 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 is 1.25 euros. Thus, an investor made a profit of 0.25 euros for each euro involved in the trade. This may not seem like much, but the total can add up if large sums of money are used.
Some investors have been known to deploy a “triangular” arbitrage strategy involving three currencies and banks.
For example, you could exchange 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.
Investors can exploit different interest rates in foreign countries in a similar fashion. Covered interest rate arbitrage is a trading strategy in which an investor can utilize something called a “forward contract” to eliminate their exposure to changes in exchange rates.
Risks in Arbitrage
Investors sometimes refer to this type of arbitrage as “risk-free,” or pure, arbitrage, because unlike selecting stocks or bonds, it doesn’t involve betting on the future performance of an asset.
In reality, however, any type of arbitrage involves risk. One key risk is that prices and rates change frequently and rapidly, so there’s always a chance that you may execute a trade at a different price than you anticipated. (This is referred to as “slippage.”)
Other potential risks include:
- Transaction fees, which can cut into your overall profit
- Taxes, including possible differing tax treatments in foreign countries
The Bottom Line
It’s entirely possible to make money through arbitrage and take advantage of the inefficiencies in capital markets. However, arbitrage strategies can be complex and often require some knowledge of foreign exchange markets. Moreover, the discrepancies in prices and exchange rates are often so small that it requires large sums of money in order to make a noticeable profit.