Arbitrage

Arbitrage is the process whereby traders profit from price discrepancies between markets. Certain conditions must be met for arbitrage to occur. The profit opportunity must be a riskless one, meaning that the transactions (buying in one market and selling in the other) must occur as near to simultaneously as possible, and the prices at which the asset is traded are both known with certainty at the time of the trade. If these conditions are met, the trader will gain the profit without tying up any capital.

Arbitrage activities contribute to the “law of one price,” a fundamental economic assumption that an efficient market will ensure at any time only one price prevails for a particular asset. Arbitrage drives prices together and is implicit within the concept of a perfect market (another way of describing the “law of one price”). Buying increases demand for the cheaper asset forcing its price up, while the higher price in the other market falls as the cheaper asset is introduced into the supply to that market.

The English word arbitrage is derived from the French arbiter, meaning to umpire or referee and so, by extension, to resolve differences. Traders who perform these activities are arbitrageurs. In immature markets, opportunities for arbitrage will be greater than in mature markets with widespread access to information.

In practice, all trading activity involves transaction costs, even if only very small. For arbitrage profits, any transaction costs must be less than the difference between the two anomalous prices and known at the time of the trade. The profit will be the net value of the price differences less transaction costs. Examples of transaction costs might be dealing charges, or transaction taxes. There is rarely such a thing as an entirely riskless transaction. Even computerized trades of currencies, for example, will involve a transaction delay, even if only a matter of seconds, during which the opportunity may disappear.

Arbitrage is not speculation. Speculators take risks and expose themselves to changes in price of the assets in which they take a position. Their objective is profit but they are prepared to risk losses to make gains. Speculators back their own judgment and may misjudge the direction markets take. Arbitrageurs take a certain profit from temporary market price anomalies and in doing so will remove those anomalies. Some arbitrageurs are occasional opportunists, but others engage in the process full time. In efficient markets profits on arbitrage may appear to be small relative to the value of the transaction, but when adjusted to an equivalent annual return and taking into account the riskless nature of the profit, the return may be high. Many financial institutions conduct arbitrage operations on a regular basis. The scale of their operations means that a high volume of operations compensates for the low margins. By conducting their own inhouse dealing operations scale economies minimize their transaction costs.

In the real economy, firms may practice price discrimination by segmenting buyers and charging different prices according to their different price elasticities of demand. Arbitrage may not be possible between the price segments because of barriers between them. For example, the recipient of a discount price could not sell at a smaller discount to the normal price to make a profit because of the supplier's customer identity conditions. Thus a student could not sell a discount travel ticket to a full-fare-paying customer who had no student identification.

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