In finance and economics, arbitrage refers to several logically related transactions aimed at extracting profits from the difference in prices. Arbitrage can pertain to the same or related assets at the same time in different markets or in the same market at different points in time. Individuals engaging in arbitrage are called arbitrageurs.
What Is Arbitrage?
It is the practice of benefiting from a price difference between two or more markets.
Trading both the financial instruments (stocks, bonds, derivatives, currencies), as well as goods and services, can refer to arbitrage. The nature of the market (exchange or over-the-counter) is not a criterion.
If we combine arbitrage in space and in time, then all speculative trading (including exchange trading) is arbitrary in nature. However, the realization of the produced goods or services is not arbitrage, although they may not differ from ordinary speculative trading.
A separate form of arbitrage is the so-called regulatory arbitrage, in which the profit is extracted due to the difference in the regulatory framework in different (national, regional, or local) jurisdictions.
Types of Arbitrage
There are the following types of arbitrage:
The key characteristic of spatial arbitrage is the complete (or almost complete) absence of risks associated with the general market price movement of assets. Here are some examples:
Buying grain in one country and immediately signing a contract for the supply of this grain in another country.
Buying shares on one stock exchange and selling them on another. On exchange A, an application was submitted to purchase 100 shares of a certain company for 18 cents, and on exchange B - to sell 100 shares of the same company for 17 cents. If the speculator notices this, they can accept both bids and make a profit of $1 (1 cent per each of the 100 shares).
The transfer of labor-intensive industries to countries with cheaper labor is an example of an arbitrage operation in the labor markets of different countries.
Example: Purchasing a call option for $100 for the right to receive gold at the end of the month at a price of $900 and concluding a contract for the supply of gold at the end of the month at a price of $1001. A special feature of options trading is that delivery prices remain unchanged, and the size of the premium usually changes more slowly than the price of the underlying asset.
Example: Counter transactions with futures contracts that have different delivery times. The difference between the prices of these contracts is usually called the basis or calendar spread. In essence, such a strategy involves trading this calendar spread.
This type of arbitrage is achieved, for example, by betting on all possible results of a competition in different bookmakers. As in the case of economic financial instruments, the theoretical probability of making a profit is 100% and does not depend on the outcome of the competition. But this is also related to the problem of ensuring the simultaneousness and success of transactions, as well as the difference in rules in irregular cases. Profit in such transactions rarely exceeds a few percents.
Limitations of Arbitrage
Arbitrage is beneficial if the price difference exceeds the commission and other related expenses (e.g. the transportation, storage, re-issuance, customs fees, etc.). In the above example of spatial arbitrage with shares, it can turn out that the exchanges are served in different systems. As a result, you will need to pay a fixed fee of $30 to transfer shares from one system to another, so transactions for 100 shares will incur a loss of $29. To profit from such transactions, you need a trading volume of more than 3,000 shares.