• Shahn Khan

What is Arbitrage?

Arbitrage refers to buying and selling the same security (generally refers to stocks, bonds, currencies, and other financial instruments) on different markets and at different price points. For instance, if stock XYZ is trading at $10 on one market and $10.50 on another, the trader could buy X shares for $10 and sell them for $10.50 on the other market, pocketing the difference.

Essentially, arbitrage can exist because of inefficiencies in the market, and if arbitrage is found, it can be a risk-free way to earn a profit.

Arbitrage is possible when 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.

Timing is everything in arbitrage. If you hold on to your shares while the markets correct themselves, for example, you could miss out on the price discrepancies you need to make a profit.

However, arbitrage opportunities are often hard to come by, due to transaction costs, the costs involved with finding an arbitrage opportunity, and the number of people who are also looking for that opportunity. Arbitrage profits are generally short-lived, as the buying and selling of assets will change the price of those assets in such a way as to eliminate that arbitrage opportunity.

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