Arbitrage
What is Arbitrage?
Arbitrage is buying an asset in one market while selling the same asset at a higher price in another, locking in a profit with no exposure to price moves.
A true arbitrage needs the same asset, or two bundles that are economically identical, priced differently at the same moment. The trader buys where it is cheap and sells where it is dear in one motion, so the position closes immediately and the profit does not depend on which way prices go next. Those trades themselves push the low price up and the high price down, which is why observable gaps are small, short-lived and mostly captured by fast automated traders. This mechanism enforces the law of one price and keeps currency cross rates consistent with each other. Arbitrage is not speculation: a speculator holds a position and bears the risk of the price moving, while an arbitrageur is hedged by construction.
Arbitrage: a worked example
Shares of one company are quoted at $50.00 on one exchange and $50.20 on another at the same instant. A trader buys 10,000 shares for $500,000 and simultaneously sells 10,000 shares for $502,000, a gross gain of $2,000. Trading fees and the price impact of the orders come to $1,500, leaving $500. The trade also destroys the opportunity it used: buying pressure lifts the $50.00 quote and selling pressure pushes the $50.20 quote down until the two prices meet.
The mistake students make with arbitrage
Students call any clever or profitable trade arbitrage, including buying a stock they expect to rise. Buying and waiting is speculation, because the payoff depends on where the price goes next. Arbitrage requires offsetting positions taken at the same time in the same or an equivalent asset, so the result is locked in the moment the trade is placed. If you have to hold the asset and hope, it is not arbitrage.
Arbitrage questions
Is arbitrage legal?
Yes, arbitrage is legal and is routine work for trading firms in every major market. It becomes illegal only when the trade depends on something else that is illegal, such as acting on inside information. Regulators generally treat arbitrage as useful, because it pulls prices at different venues back into line.
What is triangular arbitrage?
Triangular arbitrage is a currency trade that exploits an inconsistency among three exchange rates. A trader converts currency A into B, B into C and C back into A, and if the quoted cross rates do not line up, the round trip ends with more of currency A than it started with. Banks monitor these gaps constantly, so they rarely survive long.
How does arbitrage relate to the law of one price?
Arbitrage is the mechanism that enforces the law of one price, the principle that identical goods or assets should sell for the same price everywhere once transport costs and trade barriers are counted. Whenever prices diverge, arbitrageurs trade until the gap closes. Where arbitrage is blocked by shipping costs, tariffs or capital controls, price differences can persist.
Formula / Example
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