The concept of arbitrage includes buying securities in one market and then selling them in another. This practice gives the investors a chance to reap profit from the price differences of a single security traded in more than one market. Typically, arbitrage means the simultaneous purchase and sale of similar securities in different markets while taking advantage of the price discrepancy.
When the concept of arbitrage is used by academics it means a transaction that involves no negative cash flow at any temporal state. The person engaged in arbitrage is called an arbitrageur. The term arbitrage is primarily used in the trading of financial instruments like stocks, bonds, derivatives, currencies and commodities. The term Statistical Arbitrage defines an imbalance in the expected values. For example, almost every game of chance in a casino shows statistical arbitrage.
In the cases when the capital market prices do not allow a favorable situation for profitable arbitrage, the prices of the securities are then said to compose an arbitrage-free market or arbitrage equilibrium. The arbitrage equilibrium is considered to be the precondition for general economic equilibrium. In order to calculate a unique risk neutral price for the derivatives the assumption that there is no arbitrage in the market is used.
Arbitrage is not that simple to handle. More than the act of buying a product in one market and selling it in another market for a higher price, a successful arbitrageur has to take into consideration a number of market factors. The transactions should be done in such a way so that it avoids exposure to market risk. With this risk, the prices of the securities may change in one market even before both the transactions are complete.
Conditions of Arbitrage
Arbitrage in a market is possible when one of three following conditions is satisfied:
- According to "the law of one price", the same asset is not traded at the same price on all the markets.
- Two assets having identical cash flows are not traded at the same price in the market.
- The asset whose future price is known is not traded today at its future price discounted at the risk-free interest rate.
Various types of arbitrage are:
- Merger Arbitrage
- Municipal Bond Arbitrage
- Convertible Bond Arbitrage
- Depository Receipts
- Regulatory Arbitrage
- Telecom Arbitrage
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