Arbitrage refers to the practice of simultaneously buying and selling an investment in order to profit from a difference in price. Essentially, arbitrage can exist because of inefficiencies in the market, and if an arbitrage is found, it can be a risk-free way to earn a profit.
The basic concept of arbitrage is to buy an asset while simultaneously selling it (or a substantially identical asset) at a higher price, profiting from the difference. Since the transactions occur at the same time, there is no holding period, hence this is a risk-free profit strategy. While the term can be used to describe this type of transaction involving any asset type, it generally refers to stocks, bonds, currencies, and other financial instruments.
There are three basic conditions under which arbitrage is possible:
- The same asset trades for different prices in different markets. Consider the following example: A certain stock is trading on the NASDAQ for $50 per share, and is trading on a foreign market for $50.25 per share. By simultaneously buying the stock for the lower price and selling it for the higher one, a trader can make a quick, risk-free profit of $0.25 per share. Thanks to technology and high-frequency trading systems, arbitrage examples like this don't typically occur in the real world, and if they do, they last for a second or two.
- Assets with the same cash flows trade for different prices. For example, if a two bonds sell for $990 and $1,000, but both pay $50 per year in interest, there is an arbitrage opportunity to buy the cheaper one and sell the more expensive one.
- Assets with a known future price trade at a discount today, in relation to the risk-free interest rate. Let's say that company X is to be acquired for $100 per share in one month, and the deal has been approved by regulators and both companies' boards. However, the stock trades for $98 per share. By purchasing shares and holding until the acquisition is finalized, a risk-free $2 per share profit can be made.
In the real world, completely risk-free arbitrage opportunities generally don't exist. Rather, the goal of arbitrage in practice is to stack the odds in your favor. Think of a casino -- while there is an inherent risk that the casino could lose money, the odds are in its favor, and over time there is an expectation of profit.
In the example of a pending merger discussed earlier, there is always a chance the deal will fall apart up until it's actually finalized -- however, the chance is usually extremely small, especially after it's been approved.
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