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Making money requires risk. For an investor this means rolling the dice on a company or fund. You hope that it will earn a profit (or even hit that holy grail of outperforming the market), knowing that it might not. Maybe you've seen the last of that money.

That's true of virtually all investments virtually all of the time. There's no way to eliminate the element of risk. Except when it comes to arbitrage.

What Is Arbitrage?

Arbitrage happens when the same asset has different prices across markets or participants. When this happens an investor can buy and then immediately sell that asset (or vice versa) and profit off of the price differential.

The process of simultaneously buying and selling the same asset, or substantially similar assets, is known as arbitrage.

How Does Arbitrage Work?

In arbitrage, an investor finds multiple markets for an asset. Sometimes this can mean open marketplaces, such as a trading floor like the New York Stock Exchange and NASDAQ. Other times it can mean individual traders in a product. She will then look for price differences in this asset across these marketplaces.

Once she finds a price differential, even a small one, she will execute two trades at the same time: buying the asset from the lower-priced market and selling it on the higher-priced market. She profits off of the price differential per unit. Typically, since markets typically have very small variances in price, an arbitrage trader will work with very large volumes, capturing a profit on potentially fractions of a penny per unit.

Arbitrage is effective because the trader has no holding time. Since both transactions happen simultaneously there's almost no opportunity for prices to change, locking profits in at the moment of the transaction.

Example of Arbitrage

Allen is a day trader, so he spends all day looking for short term changes in value across stocks.

One afternoon he finds ABC Co. listed on the New York Stock Exchange for $10. He sees that this price change hasn't caught up with the London Stock Exchange yet, where it is still listed for $9.98.

He buys 100,000 shares of ABC Co. on the London Stock Exchange. At the same time he executes a sell order for 100,000 shares of ABC Co. on the New York Stock Exchange. This is permissible because he will own the shares of stock when it is time to deliver on his transaction.

Allen's trade has no risks because already knows (in fact has already acted on) his profit margin. The price difference means that Allen will sell his shares for 2 cents more then he bought them, netting him an immediate $2,000 profit.

Common Conditions for Arbitrage

The conditions for arbitrage are most commonly caused by three circumstances. It often plays a crucial role in correcting these conditions.

1. Unequal Information

Participants in various markets have access to different information leading them to value an asset differently. This is much less common in modern trading than it once was. Communications technology has created an instant, global network of publicly available information and price changes in an asset are communicated around the world immediately.

The truth is that Allen's trade, in our example above, probably wouldn't happen. Prices tend not to lag in a networked world. Here, traders in London would have seen the price of ABC Co. rise in New York as it happened and would most likely adjust their trades accordingly. However, if it did happen arbitrage would help correct the information gap, as the rush of outside traders would alert traders in London that they had missed something.

2. Inefficient Markets

"Inefficiency" is when a market's prices don't match an asset's true value. This can happen for any number of reasons, including: unequal information, speculation, political climate and much more.

A good example of market inefficiency was the U.S. housing market shortly before its 2008 collapse. Widespread speculation led investors to vastly overvalue residential real estate, creating a highly inefficient market which ultimately led to a correction that caused the Great Recession.

When one market is behaving less efficiently than another this will create a price gap that arbitrage traders can take advantage of. In doing so, arbitrage traders will help correct the market inefficiencies. By buying heavily from the undervalued market or selling heavily in an overvalued one, arbitrage helps correct prices toward true value.

3. Uncertain Valuation

Sometimes markets operate both efficiently and on perfect information but still price an asset differently. This often happens when traders simply disagree on what true value actually is.

A very common example is in blockchain trading. This is a highly speculative asset class with significant market inefficiencies, but also a widespread debate on actual value. Investors differ in what they think individual cryptocurrencies are worth (or even on what the entire concept of cryptocurrency) and so trade the same tokens for different prices.

If the investors in one market think an asset has a true value of $50 per unit and the investors in another market think its true value is closer to $45, an arbitrage opportunity exists. In executing this arbitrage opportunity traders can help multiple marketplaces determine a true trading value, buying and selling until this price gap is closed.

Other Examples Of Arbitrage

Let's look at a few more examples of arbitrage opportunities.

Capturing a Bubble

High volume trading on the Chicago Mercantile Exchange has pushed the price of gold way up over the past five minutes. Since this was caused by a flurry of short term trades the price hasn't yet reached New York yet and will probably drop back down in the next several minutes.

Before that happens, our trader can purchase gold futures on the New York Mercantile Exchange and sell them on the Chicago Mercantile Exchange. This will capture the price difference driven by short-term trading and also help to bring the price of gold back down, preventing a short term flurry of trades from becoming a long term bubble.

Currency Exchanges

Bank Paris has priced the Dollar/Euro at 1.50/0.66. Bank Moscow, due to political pressure, has priced the dollar lower, at 1/0.62. This is an example of an inefficient market, as the prices have been influenced by external factors.

Here, traders could take advantage of this by converting dollars to euros with Bank Paris, then converting those euros back to dollars with Bank Moscow. The trader would turn $1.50 into 1 euro, then turn that same 1 euro into $1.60. This would continue until Bank Moscow either changed its price, discontinued trading or simply ran out of dollars.

Substantial Similarity

Arbitrage can also happen when you trade substantially identical assets, even if they are not technically the same.

For example, Company A has issued a triple-A rated 20-year bond for $100 that will pay $10 per year in interest. Bank B has issued a triple-A rated 20-year bond for $110 that also pays $10 per year in interest. Assuming no other differences, these two products are functionally identical. An arbitrage trader would therefore be able to execute simultaneous purchase and sale of 20-year, AAA, $10-per-year bond, even if the assets were actually issued by different institutions.

What Is Triangular Arbitrage?

Triangular arbitrage is a form of currency trading. While, like all arbitrage, it is relatively uncommon, it happens far more often than our direct swap example above.

In triangular arbitrage a trader swaps three different currencies for a final profit, exploiting a difference across the prices that would not be obvious by looking at each currency swap alone. For example:

  • Bank A prices the Dollar/Euro at 1/0.83
  • Bank B prices the Euro/Pound at 1/0.9
  • Bank C prices the Pound/Dollar at 1/1.18

A triangular arbitrage would then execute the following trades simultaneously:

  • Convert USD 10,000 into EUR 8,333.
  • Convert EUR 8,333 into GBP 9,259.
  • Convert GBP 9,259 into USD 10,925.

The price differences across each bank result in an ultimate, and immediate, profit of almost $1,000.

Mergers

Finally, the following situation is commonly referred to as arbitrage:

ABC Co. is the target of an acquisition. In two months the stock will be acquired for $12 per share. Although the deal has been approved and the contracts have been signed, the stock is still trading for $10 per share. Allen can buy the stock in bulk and hold it for two months until the deal pushes the stock price to $12.

Since this new price is theoretically guaranteed, this is referred to as arbitrage. Allen is taking advantage of a known price differential, even though the difference is across time rather than markets. However, it is not a classic example of arbitrage because Allen in fact is not certain of the change in ABC Co.'s price. While the merger makes his profits highly likely, it is still possible for something to disrupt this acquisition over the coming two months. This introduces an element of risk not found in traditional arbitrage.

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