Arbitrage

Arbitrage is the process of simultaneously transacting in multiple financial securities to make a profit from the difference in prices. This can be done in various ways such as the purchase and sale of same securities in different markets (Spatial Arbitrage) or simultaneous buying and selling of spot prices and futures contract of a security or buying the stock of a company being acquired while selling the stock of the acquiring company (Merger Arbitrage). Arbitrage can be applied to financial instruments such as stocks, bonds, derivatives, and commodities etc.

Arbitrage is a risk-free strategy, although this is not always the case. There is always a possibility of execution risk, i.e. risk due to high volatility in the market and a sudden change in price makes it impossible to close the trade at a profitable price. Other risks involved are counterparty risk and liquidity risk.

Example

Suppose a company ABC’s stock trades at $10 per share on the London Stock Exchange and the same stock trades at $10.5 on the New York Stock Exchange, an arbitrage strategy would be to purchase the stock at $10 on the LSE and sell it for $10.5 on the NYSE, making a profit of $0.5 per share.