What is Arbitrage?
Arbitrage is the strategy of taking advantage of the price differences of the same asset. For it to take place, there must be a situation of – at least – two equivalent assets with differing prices. In essence, arbitrage is a situation that a trader can profit from the imbalance of asset prices in different markets. The simplest form of arbitrage is purchasing an asset in the market where the price is lower and simultaneously selling the asset in the market where the asset’s price is higher.
Arbitrage is a widely used trading strategy, and probably one of the oldest trading strategies to exist. Traders who engage in the strategy are called arbitrageurs.
The concept is closely related with the market efficiency theory. The theory states that for markets to be perfectly efficient, there must be no arbitrage opportunities, and all equivalent assets would converge to the same price, The convergence of the prices in different markets measures the market efficiency.
Both the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory explain that arbitrage opportunities occur due to the mispricing of assets. If the opportunities are fully explored, the prices of equivalent assets should converge.
A Simple Example
Warren Buffett at 6 years old saw that he could profit from arbitrage. He would purchase a 6-pack of Coca-Cola for 25¢ and sell each can for 5¢ in his neighborhood, profiting 5¢ per pack. Young Warren Buffett saw that he could profit from the difference price that his grandmother charged, and that other people were willing to pay at different parts of time.
A More Complex Example
A very common example of arbitrage opportunities is for cross-border listed companies. Let’s say hypothetically, a Canadian Bank owns stocks listed in Canada’s TSX that trade at $10.00 CAD, and at the same time, with stocks listed on the NYSE that trade at $8.00 USD. If the current CAD/USD rate is 1.10, a trader could purchase a share of the Canadian bank in the NYSE for $8.00 USD, then sell it in the TSX for $10.00 CAD, convert his money into $9.09USD and have a profit of 1.09 USD.
Conditions for Arbitrage
Arbitrage may occur if the following conditions are met:
- Asset’s price imbalance: It is the primary condition of arbitrage. The price imbalance can take various forms:
- In different markets, the same asset is traded at different prices.
- The assets with similar cash flows are traded at different prices.
- The asset with the known future price currently traded at a price different from the expected value of the future cash flows.
- Simultaneous trade execution: The purchase and sale of an asset should be executed simultaneously to capture the price differences. If the transactions are not executed simultaneously, the trade will be exposed to significant risks.
Trading with Arbitrage
Even though this a simple strategy very few – if any – investment funds rely solely on such a strategy. The fact can be explained by the difficulties associated with exploiting the commonly short-lived situation. With the rise of electronic trading, which can execute trade orders within a fraction of a second, mispriced asset differences occur for a minuscule amount of time. The improved trading speed has, in this sense, improved the efficiency of markets.
In addition, equal assets with different prices generally show a small difference in price, that is many times smaller than the transaction cost; therefore, making the arbitrage opportunity not economically sensible.
Arbitrage is generally exploited by large financial institutions because it requires significant resources to identify the opportunities and execute the trade. They are often performed with the use of complex financial instruments, such as derivative contracts and other forms of synthetic instruments to find equivalent assets, which are not necessarily the same. Derivative trading frequently involves the margin trading and a large amount of cash required to execute the trades.
Paintings are alternative assets with a subjective value and tend to give rise to arbitrage opportunities. For example, a local painter might see his paintings sell for cheap in one country but in another culture, where his painting style is more appreciated, he can sell them for more.
CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ designation, a leading financial analyst certification program. To continue learning and advancing your financial career, these additional resources will be helpful: