Arbitrage

A SIMPLE definition of arbitrage comes from http://Investorwords.com: “Attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.”

Arbitrage is possible because markets are driven by imperfect information. It is therefore possible for the same security to have one value in New York and a slightly different value in London. When dealing with large amounts of securities, a difference of a fraction of a cent can yield substantial profits for the clever arbitrageur.

The classic, almost risk-free form of arbitrage is taking advantage of small differences in the pricing of foreign currencies. Let's say that one dollar in United States currency is considered equivalent, today, to 0.85 euros. One euro is trading for 260 Hungarian forints. And one Hungarian forint is trading for 0.00475 U.S. dollars. A currency arbitrageur [Page 48]with $100 buys 85 euros. She then trades her 85 euros for 22,100 Hungarian forints. Finally, she trades her 22,100 Hungarian forints for $105. Based on a small mismatch in currency values, she has made a 5 percent profit.

Speculating on the different prices of world currencies at a given point in time in several different locations is one form of arbitrage. Arbitrageurs can yield great profits from small currency fluctuations.

However, our arbitrageur probably will not be able to make the same maneuvers tomorrow, as her own actions are part of the market. As other traders see and respond to her trades, the values of the three currencies will tend to adjust into closer parity. At some point, the small differences in value will become smaller than the costs of the transaction, removing the opportunities for arbitrage.

This basic example points to the value and perils of more complex forms of arbitrage. Arbitrage is valuable to markets because it gradually adjusts mismatches in value, creating a more rational market. At the same time, arbitrage opportunities are few, difficult to identify, rarely greater than their own transaction costs, and tend to eliminate themselves through their own effectiveness. Successful arbitrage in more complex securities markets can be a difficult investment strategy to pursue without illegal insider information.