Arbitrage is the strategy of taking advantage of price differences in different markets for the same asset. It is an operation in which a person buys goods in one (cheaper) market and sells in another (dearer) market in order to make a profit out of the price difference. It happens when a security is purchased in one market and simultaneously sold in another at a higher price. It is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. While getting into an arbitrage trade, the quantity of the underlying asset bought and sold should be the same. It is a widely used trading strategy, and probably one of the oldest trading strategies to exist. Traders who engage in the strategy are called arbitrageurs.
Arbitrage is possible when one of three conditions is met:
- The same asset does not trade at the same price on all markets (“the law of one price”).
- Two assets with identical cash flows do not trade at the same price.
- An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset has significant costs of storage; as such, for example, this condition holds for grain but not for securities).
Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader. Arbitrage is considered a risk-free profit for the investor or trader. It provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. For example, if Company XYZ’s stock trades at $5.00 per share on the New York Stock Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 — pocketing the difference of $0.05 per share.