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In economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur. Statistical arbitrage is an imbalance in expected values. A casino has a statistical arbitrage in every game of chance played, even though it could lose money on any single game.
1 Conditions for arbitrage
Arbitrage is possible when one of three conditions is not met:
- The same asset must trade at the same price on all markets ("the law of one price").
- Two assets with identical cash flows must trade at the same price.
- An asset with a known price in the future, must today trade at its future price discounted at the risk free rate.
- See Rational pricing, particularly Arbitrage mechanics, for further discussion.
The term "arbitrage", is usually applied only to trading in money and investment instruments (such as stocks, bonds, and other securities), not to goods, and the difference in asset prices is usually referred to as "the spread", so arbitrage is often defined as "playing the spread" in the money market.
Examples
- Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $10. Converting $10 to £6 in Tokyo and converting that £6 into $12 in London, for a profit of $2, would be arbitrage.
- One real-life example of arbitrage involves the stock market in New York and the futures market in Chicago. When the price of a stock in New York and its corresponding future in Chicago are out of sync, one can buy the less expensive one and sell the more expensive. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually.
- If you can buy items at one price at a factory outlet and sell them for a higher price on an internet auction website such as eBay, you can exploit the imbalance between those two markets for those items.
2 Price convergence
Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rateIn finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese Yen to the Dollar means that ¥120 is worth the same as $1. An exchange rate is also known ass, the price of commodities, and the price of securities in different markets all tend to converge to a fixed price. The speed at which the prices converge is one measure of the efficiency of a market. Arbitrage tends to reduce price discriminationPrice discrimination exists when sales of identical goods or services are transacted at different prices from a single vendor. Theoretically, price discrimination is a feature only of monopoly markets. In addition to a monopoly market, price discriminatio by encouraging people to buy an item where the price is low and resell where the price is high. Sellers of goods and services often attempt to prohibit or discourage arbitrage.
Arbitrage is an important factor of reaching Purchasing power parityIn economics, purchasing power parity (PPP) is a theoretical exchange rate derived from the perceived "parity" of "purchasing power" of a currency in relation to another currency. In contrast to the "real" exchange rate that the currencies are traded for between different currencies. For example if American cars are relatively cheaper than cars in Canada, Canadians would buy their cars across the border to exploit the arbitrage condition. If this happens on a larger scale, the higher demand for US Dollars and the higher supply of Canadian Dollars (The Canadians would have to exchange their Dollars into US Dollars.) would lead to an appreciation of the US Dollar and would eventually make US cars more expensive for Canadian buyers.
