Arbitrage is a financial practice that involves capitalizing on price discrepancies that occasionally emerge across two or more markets. This strategy is particularly prevalent in the foreign currency exchange industry. For example, money changers cater to tourists in need of quick access to local currency and often accept unfavorable exchange rates, receiving less local currency than they would at the prevailing market rate. Such price imbalances are the source of the earnings of the money changers.
Arbitrage opportunities arise in various situations, often because one market is unaware of another or cannot access it, creating price disparities.
Arbitrageurs, those who engage in arbitrage, can also benefit from differences in market liquidity. While arbitrage usually pertains to investment and currency opportunities rather than goods, it can have significant impacts on market prices.
Arbitrage activities typically lead to price convergence, where higher prices drop and lower prices rise, achieving a balance. The concept of “market efficiency” refers to how quickly these prices adjust and converge.
Some individuals make a career out of arbitrage, attracted by the potential for substantial gains and profits. However, this practice is not without risks. The primary danger lies in rapid price fluctuations between markets. For instance, spreads can change dramatically in the brief time required to execute the necessary transactions. In fast-moving markets, arbitrageurs may not only miss out on potential profits but could also incur losses if prices move unfavorably between trades.
Financial markets offer numerous examples of arbitrage. One such example is convertible arbitrage, which involves working with convertible bonds. These bonds can be exchanged for shares of the issuing company’s stock. If the value of the shares obtainable through conversion exceeds the bond’s price, an arbitrageur can profit by purchasing the bond, converting it to stock, and selling the shares on the exchange to realize the price difference.
Another form is relative value arbitrage, which utilizes options to acquire underlying shares of stock. In some cases, an option may be priced more favorably relative to the shares it can purchase. For instance, if a stock is trading at $200 and an option allowing the purchase of one share at $120 is priced at $50, an arbitrageur could buy the option, exercise it to obtain the shares, and then sell the stock for $200. This would result in a total expenditure of $170 per share and a profit of $30 per share upon sale.
