Published On:Wednesday 4 January 2012

Posted by Muhammad Atif Saeed

Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered riskless profit for the investor/trader.

Here is an example of an arbitrage opportunity. Let's say you are able to buy a toy doll for $15 in Tallahassee, Florida, but in Seattle, Washington, the doll is selling for $25. If you are able to buy the doll in Florida and sell it in the Seattle market, you can profit from the difference without any risk because the higher price of the doll in Seattle is guaranteed.

In the context of the stock market, traders often try to exploit arbitrage opportunities. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader makes a profit from this difference.

If all markets were perfectly efficient, there would never be any arbitrage opportunities - but markets seldom remain perfect. It is important to note that even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity. Transaction costs can turn a possible arbitrage situation into one that has no benefit to the potential arbitrager. Consider the scenario with the toy dolls above. It would cost you a certain amount per doll to get the dolls from Florida to Seattle. If it costs $11 per doll, the arbitrage opportunity has been erased.