Arbitrage is a financial strategy that involves simultaneously buying and selling an asset or a security in different markets to take advantage of differing prices for the same asset. The arbitrageur can make a risk-free profit from these transactions.
For example, let’s say that a stock is being sold for $100 on the New York Stock Exchange, but the same stock is being sold for $101 on the London Stock Exchange. An arbitrageur could simultaneously buy the stock for $100 in New York and sell it for $101 in London, making a $1 profit per share without any risk. This is a simplistic example; in reality, the arbitrage opportunities might be much smaller, and they usually require substantial volume to be profitable after accounting for transaction costs.
There are various forms of arbitrage:
- Spatial arbitrage: Buying in one market and selling in another, like the example above.
- Temporal arbitrage: Exploiting price differences at different times. For instance, buying a commodity when it’s cheaper in the off-season, storing it, and selling it when demand and prices are high.
- Statistical arbitrage: A complex form of arbitrage that involves making many trades, based on statistical models, to profit from price differences in the short term.
- Risk arbitrage or merger arbitrage: This involves buying and selling shares of two merging companies. The arbitrageur bets on the future stock price after the merger is complete.
- Convertible arbitrage: This strategy involves taking advantage of price differences between a convertible security (like a bond that can be converted into stock) and the stock it can be converted into.
- Regulatory arbitrage: Exploiting differences in regulatory treatment between two markets to gain a financial advantage.
In efficient markets, arbitrage opportunities are often short-lived as prices rapidly adjust to correct the imbalance. The existence of arbitrage opportunities might indicate market inefficiency.
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