Arbitrage

What is arbitrage?

Arbitrage is the practice of profiting from temporary price differences of the same or equivalent assets across different markets or instruments. By buying where the price is lower and simultaneously selling where it is higher, an arbitrageur captures the price gap. In theory these trades are risk-free, but in practice they are constrained by transaction costs, execution speed, and other frictions.

How arbitrage works

• Arbitrage exploits market inefficiencies—moments when prices do not reflect an asset’s fair value across venues.
• Traders simultaneously buy the underpriced instrument and sell the overpriced one to lock in the spread.
• Modern arbitrage relies heavily on speed and automation: opportunities are often eliminated in seconds by computerized systems.
• Most arbitrage activity occurs in highly liquid markets (major stocks, futures, currencies) where the same asset can be traded in multiple places.

Common types of arbitrage

• Spatial arbitrage: Buy and sell the same asset on two exchanges (e.g., NYSE vs. LSE).
• Triangular arbitrage: Use three currency pairs to convert one currency through two others and back to the original currency to profit from inconsistencies in FX rates.
• Statistical arbitrage: Use quantitative models to exploit small, statistically expected divergences among related securities.
• Merger (event) arbitrage: Trade shares based on expected outcomes of corporate events like mergers or acquisitions.
• Convertible arbitrage, retail arbitrage, negative arbitrage and others: Variations that use specific instruments or market conditions.

Simple example

If Company X trades at $20 on Exchange A and $20.05 on Exchange B, an arbitrageur can:
– Buy on Exchange A at $20
– Sell on Exchange B at $20.05
Profit per share = $0.05 (ignoring fees, commissions, and execution risk). The buying pressure raises the lower price and the selling pressure lowers the higher price, narrowing the spread.

Triangular (currency) arbitrage example

Assume quoted exchange rates (interpreted as units shown):
– USD/EUR = 1.1586 (USD per EUR)
– EUR/GBP = 1.4600 (EUR per GBP)
– USD/GBP = 1.6939 (USD per GBP)

Start with $1,000,000:
1. Convert USD to EUR: 1,000,000 ÷ 1.1586 ≈ €862,998
2. Convert EUR to GBP: €862,998 ÷ 1.4600 ≈ £591,096
3. Convert GBP to USD: £591,096 × 1.6939 ≈ $1,001,380

Net profit ≈ $1,380 (ignoring transaction costs, bid–ask spreads, taxes, and timing risk). If these frictions are present, they can eliminate the apparent profit.

Why arbitrage matters

• Efficiency: Arbitrageurs help align prices across markets, reducing persistent mispricings and improving overall market efficiency.
• Liquidity: Arbitrage trading adds liquidity, making it easier for other market participants to buy and sell.
• Price discovery: By exploiting and closing gaps, arbitrage contributes to accurate price discovery.

Limitations and risks

• Transaction costs, bid–ask spreads, and taxes can negate small spreads.
• Execution risk: Delays or partial fills can turn an apparent risk-free trade into a losing one.
• Capital and margin requirements: Many arbitrage strategies require substantial capital and leverage.
• Competition and technology: High-frequency trading and automated systems rapidly eliminate opportunities.
• Regulatory and operational constraints: Rules or settlement differences across markets can impede arbitrage.

Key takeaways

• Arbitrage profits from short-lived price differences across markets or instruments.
• It plays a vital role in making markets more efficient and liquid.
• True risk-free arbitrage is rare in modern markets due to transaction costs, technological competition, and execution risks.
• Successful arbitrage typically requires speed, scale, and sophisticated systems.