Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of an imbalance in prices for the same asset. The trade profits by exploiting the price differences between the market value of a combination of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.
In an academic sense, the transaction involves no negative cash flow and provides the possibility of a risk-free profit after transaction costs (although this cost assumptions is not always included). For example, instantaneously buy something for a low price and selling it for a higher price to take advantage of differences in price.
In practice, or common use, in strategies such as statistical arbitrage (relative value or convergence trades), merger arb or even CFD Arbitrage, it may refer to expected profit. Thus, capturing the differences between similar assets but where losses may occur. The risks in this type of strategy may include fluctuation of prices or currency devaluation and can have a devastating effect. In this environment, completely risk-free arbitrage opportunities generally do not exist. If they do, they are generally exploited rapidly and disappear. Instead, these strategies attempt to tilt the odds in favor of the trader.
The following list (not exhaustive) identifies different types of arbitrage strategies commonly found in the markets
The Efficient Market
In his book, Warren Buffett and the Art of Stock Arbitrage, Warren Buffet repeats a well-known Wall Street phrase,
Give a man a fish and you will feed him for a day. Teach a man to arbitrage and you will feed him forever
Thus highlighting the importance of this strategy in modern markets. However, proponents of the Efficient Market Hypothesis (EMH) believe that the only way to reliably earn more than a risk free return in the market is to accept economic risk. In the case of merger arbitrage, traders are accepting the risk that the deal does not consummate. In return, small profits can be made should the deal be successful. Despite this, opportunities can and do exist for traders who are willing to do their research and understand fully the strategy in which they are operating.
In “Dynamic Hedging: Managing Vanilla and Exotic Options” by Nassim Taleb discusses the “Orders of Arbitrage“. A table which highlights first order arbitrage consisting of conversions and reversals in the option market moving across the spectrum to third order arbitrage such as cross-market relationships and volatility plays.
Arbitrage Example
Consider the following. The stock of AstraZeneca (LSE: AZN) on the London Stock Exchange frequently traded 10p ($0.13) or more below the price of the equivalent ADR (NYSE: AZN) traded in New York (NYSE). By buying in London and simultaneously selling in New York traders were able to make a profit. They would of course have to hedge out any currency risk. In fact, a third “leg” of this trade was possible as AstraZeneca stock (Nasdaq Stockholm: AZN) is also traded on the Nasdaq Stockholm exchange (formerly known as the. Frequent opportunities could occur with this additional leg although an extra FOREX trade would be required. However, over time more traders in a crowded market place eliminated this opportunity as the markets took another step towards efficiency.
