Arbitrage

Arbitrage means simultaneous buying and selling of the same asset across markets as a means to generate profit from price differences. This implies short-term fluctuations in the price of similar derivative instruments in different markets. 

Arbitrage occurs in case of market inefficiencies, while using these issues and resolving them. 

Essence of the term

In fact, arbitrage is applied to purchasing any shares, commodities, or currencies in the same market at a predetermined price followed by their consecutive selling in the other one with a higher pricing solution. This is the case for receiving a risk-free profit by traders.

Arbitrage provides a certain mechanism to make sure that prices don’t diverge greatly from fair value in the long run. With technological advances, the process of profit generating from price errors has become extremely sophisticated. Lots of market participants take into account digital trading systems designed to monitor market fluctuations of the same financial instruments. As a rule, all underperforming pricing configurations are eliminated within seconds, so that there is almost no possibility to benefit.

The so-called arbitrageurs usually operate on behalf of large financial corporations. Considerable amount of monetary means is needed, while the possibilities provided can only be seized with sophisticated software. 

Real life examples

To illustrate the mentioned theory, let’s dive into the practice. The stocks of the Y enterprise are trading $30 per share on the Hong Kong Stock Exchange. Concurrently, they are presented on the FWB valued at $25. Traders are able to generate profit by purchasing with a lower cost and selling at a higher one. Therefore, the gains may amount to $5. 

Or, the other option is possible. An arbitrage can come into play when the Hong Kong Stock Exchange runs out of stocks. Otherwise, it is worth waiting for price corrections on both exchanges to foreclose the possibility. 

Note: stock exchanges of different countries may offer the company’s securities in various forms. To top it off, the quote currencies are also different. 

Complex Arbitrage

Of course, there exists a more complicated case of using arbitrage. Let’s call it triangular. The principle is quite obvious. A trader converts one currency into another. The following step is to transform the second currency into the third banking institution. And, finally, the last move is to convert the third currency into the original one. 

With these transactions a market player can receive an arbitrage profit if there are no operational costs or taxes.

Sometimes the process of arbitrage is applied to another trading activity. Therefore, merger arbitrage is one of the most popular strategies for hedge fund investors, anticipating a purchase of company’s stocks prior to the awaited merger.

Concept significance for the market

The efficiency of the financial markets may increase due to the arbitrage operations. By assets’ purchasing and selling, a price gap narrows. So, financial tools with lower costs are inflated, while instruments with the higher ones are sold off. 

In other words, prices may align, as a consequence of arbitrage transactions. The process speed serves as a measure of market efficiency. Arbitrage also stimulates forming the exchange rates based on purchasing power parity.