What Is Arbitrage? Definition, Example, and Costs

Reviewed by Samantha SilbersteinReviewed by Samantha Silberstein

Arbitrage is a fundamental concept in finance, playing a crucial role in determining prices for assets like currencies, stocks, and much more. It refers to the simultaneous buying and selling of an asset in different markets to profit from any price differences. Many economic models presume these opportunities for profiting shouldn’t exist—and yet many make a living by exploiting these discrepancies.

Suppose you discover a store selling brand-new, latest-model iPhones for $500 while every other retailer is charging $1,000 or more. What would you do? If you were an arbitrageur, you’d buy as many phones as possible from the store with the deal and immediately sell them elsewhere for a quick, low-risk profit. This is the core principle of arbitrage—taking advantage of price differences to make a profit.

Key Takeaways

• Arbitrage is when an asset (stocks, currencies, etc.) is bought in one market and sold in another for a higher price.
• The types of arbitrage are spatial, statistical, and merger arbitrage.
• The temporary price difference for the same asset between the two markets lets traders lock in profits.
• Some benefits of arbitrage include riskless profits, market efficiency, increased liquidity, and income diversification.
• The potential downsides of arbitrage include transaction costs, as well as liquidity, model, legal, and regulatory risks.

Arbitrage is the financial equivalent of bargain hunting on a grand scale, with traders and investors constantly searching—using the latest algorithms and fastest internet speeds to act in microseconds—for opportunities to buy low in one market and sell higher in another. However, unlike the iPhone example above, these prospects in financial markets are often fleeting, small, and require split-second decisions and sophisticated technology to exploit.

Arbitrage plays a crucial role in making markets function and setting prices. It’s more than a way for savvy traders to make money. It helps to keep prices consistent across different markets and ensures that similar assets are priced fairly relative to each other. When arbitrageurs act on price discrepancies, they inadvertently push prices back into alignment, making markets more efficient.

From currency exchange rates to stock prices to the cost of goods in different countries, the principle of arbitrage influences most aspects of the global economy. Understanding arbitrage thus provides crucial insights into how financial markets work, why prices move the way they do, and how traders and investors make decisions, all of which we explore in the following sections.

Note

Michael Lewis’s 2014 book “Flash Boys” brought wider attention to how some high-frequency traders were making millions through latency arbitrage, profiting from microsecond advantages in trading speed. It sparked a fierce debate about fairness in modern financial markets, though the book didn’t gain as wide attention as “The Big Short” (2010) or “Going Infinite” (2023).

How Arbitrage Works

Arbitrage revolves around the principle of market efficiency, which suggests that prices in different markets should eventually converge to reflect all available information. When markets are temporarily inefficient, arbitrageurs step in to correct these discrepancies by buying low in one market and selling high in another, thus making a profit and helping restore equilibrium.

Indeed, arbitrageurs help maintain market balance and liquidity (the ability to trade assets with relative ease). In addition, the existence of arbitrage prospects means that markets are not perfectly efficient, though these opportunities are generally fleeting in nature.

Executing these trades requires a distinct and precise process that begins with identifying arbitrage opportunities. Traders often use sophisticated algorithms and real-time data feeds to spot price discrepancies across different markets. Once a prospect is identified, the trade must be executed quickly to lock in the profit before the market corrects itself.

Steps Involved in Arbitrage

Here’s a step-by-step breakdown of arbitrage using a financial example involving stock prices:

1. Spot the difference: You notice that shares of XYZ Company are trading at $100 on the New York Stock Exchange (NYSE) but at the equivalent of $101 on the Tokyo Stock Exchange.
2. Buy low: You purchase 1,000 shares of XYZ on the NYSE for $100,000.
3. Sell high: Nearly simultaneously, you sell 1,000 shares of XYZ on the Tokyo Stock Exchange for $101,000.
4. Pocket the difference: You’ve made a profit of $1,000 (minus any transaction costs) with virtually no risk.
5. Market impact: As you and other arbitrageurs repeat this process, the increased buying on the NYSE tends to push the price up, while increased selling on the Tokyo Stock Exchange tends to push the price there down.
6. Equilibrium: Eventually, the prices on both exchanges should converge, eliminating the arbitrage opportunity.
7. Repeat: You continuously monitor for new price discrepancies across different exchanges or related markets.

In practice, these opportunities are often much smaller and more complex, involving factors like exchange rates, transaction costs, and timing differences. Professional arbitrageurs use high-speed computers and sophisticated algorithms to identify and execute these trades in fractions of a second. Small delays in trading can lead to missed opportunities or diminished profits. Hence the advent of high-frequency trading (HFT) systems, which execute trades in milliseconds, often with little or no human intervention. Technology and access to real-time data are key in modern arbitrage strategies, as they provide the edge needed to capitalize in this environment.

Types of Arbitrage

There are several types of arbitrage, each with distinct characteristics. These include:

• Spatial arbitrage: This type takes advantage of price differences across geographic locales, such as buying a commodity in one country and selling it in another where the price is higher.
• Statistical arbitrage: This relies on complex mathematical models and algorithms to identify and exploit price inefficiencies across various securities. Big data analysis is usually required, and the typical statistical arbitrageur is hedge funds or quants.
• Merger arbitrage: This comes into play after a company announces its intention to acquire another. Before the acquisition is finalized, the target company’s stock might trade below the acquisition price, because of uncertainty about whether the deal will get completed. A merger arbitrageur might buy shares of the target below the acquisition price, expecting the price to return to that level once the deal is completed.

Note

Arbitrage isn’t limited to Wall Street HFT firms. So-called retail or Amazon arbitrage, where people buy products at a discount and try to resell them at a higher price online, has become a popular side hustle, with numerous Youtubers and bloggers claiming to make a living doing so.

Real-World Examples of Arbitrage

Example of Spatial Arbitrage

A real-world example of spatial arbitrage occurred in the cryptocurrency markets in December 2017. Bitcoin (BTCUSD) was trading at different prices on multiple cryptocurrency exchanges. BTCUSD was priced at around $19,000 on U.S. exchanges while trading as high as $22,000 on South Korean exchanges like Bithumb. Traders were likely buying BTCUSD on U.S. exchanges and selling it on South Korean exchanges, profiting from the price discrepancies, less transaction and transfer costs. This became known as the “Kimchi premium.”

Example of Statistical Arbitrage

Another example of statistical arbitrage concerns Long-Term Capital Management (LTCM), a hedge fund that used statistical arbitrage in the 1990s. One of their trades involved the identification of price inefficiencies between U.S. Treasury bonds, with LTCM betting that the prices of long-term and short-term bonds would align. Despite these strategies, LTCM failed catastrophically when market conditions shifted. At that point, the U.S. government, to protect other firms, had to step in with an offer of billions in emergency loans.

Here’s what happened since this is now a textbook case of the downsides of overleveraging in arbitrage trading:

1. Leveraged positions: LTCM used enormous leverage (borrowed money) to amplify potential gains from small price discrepancies. At one point, the fund had about $5 billion in equity supporting over $100 billion in borrowed money.
2. Bond arbitrage: One of LTCM’s main strategies involved statistical arbitrage between on-the-run (newly issued) and off-the-run (previously issued) Treasuries. Its traders were betting that the price difference between these similar bonds would narrow—as models had shown they had done historically time and again.
3. Global events: In 1998, Russia defaulted on its debt, causing a “flight to quality” in global markets. Investors rushed to buy the most liquid government bonds, widening the spreads LTCM had bet would narrow.
4. Correlation breakdown: Many of LTCM’s positions, which were supposed to offset each other, suddenly became correlated, leading to significant losses across the board.
5. Liquidity crisis: As LTCM’s positions moved against them, they needed to unwind trades, but the sheer size of their positions made this difficult without causing others in the market to move against them.
6. Systemic risk: LTCM’s potential collapse threatened the broader financial system, leading to a bailout orchestrated by the Federal Reserve.

The LTCM case illustrates that while arbitrage strategies can be low-risk in normal market conditions, they can become extremely risky during periods of market stress, especially when combined with high leverage. It also demonstrates that what appears to be “arbitrage” (with supposedly “riskless” gains) can sometimes involve hidden risks that soon become apparent in extreme circumstances.

Important

Price discrepancies across markets are generally minute in size, so arbitrage strategies are practical only for investors with substantial assets to invest in a single trade—or many, many trades so these small differences add up.

Example of Merger Arbitrage

The acquisition of LinkedIn in 2016 by Microsoft (MSFT) is an example of merger arbitrage. When MSFT announced its intention to buy LinkedIn for $26.2 billion, or $196 per share, LinkedIn’s stock, trading around $131 per share before the announcement, quickly jumped. Nevertheless, it still traded below the offer price because of uncertainty about the deal’s completion.

Merger arbitrageurs could have used this chance to buy the shares at a discount to the offer price. As the deal progressed and regulatory approvals were secured, LinkedIn’s stock price inched toward the $196 offer price. Once the deal was completed, the arbitrageurs who had bought the target shares earlier could profit from the difference.

Benefits and Risks of Arbitrage

Benefits

• Risk-free profits

• Improves market efficiency

• Increased liquidity

• Income diversification

Risks

• Execution risk

• Transaction costs

• Liquidity risk

• Model risk

• Legal and regulatory risks

Benefits of Arbitrage

Some of the benefits of arbitrage include the following:

• Risk-free profits: Traders can earn profits with minimal or no risk, as arbitrage exploits price discrepancies across various markets.
• Market efficiency: By identifying and exploiting price discrepancies, arbitrageurs help align prices, ensuring that securities are fairly valued.
• Liquidity improvement: Market liquidity often increases when arbitrageurs are around. Increased liquidity benefits all market participants by narrowing bid-ask spreads and making it easier to buy and sell assets.
• Income diversification: Traders can diversify their income through an additional strategy such as arbitrage. This strategy does not rely on market direction and can generate profits regardless of broader market trends, mitigating potential profit loss when market volatility occurs.

Note

Estimates put about half of all trading across the U.S. (up to 60%) and Europe (about 35%) in the high-frequency category. HFT companies employ diverse strategies, including arbitrage.

Drawbacks of Arbitrage

Like any strategy, arbitrage has its downsides:

• Execution risk: The profitability of an arbitrage strategy depends very much on a trader’s ability to execute precise traders very quickly. Delays, errors in trade execution, or system failures can erode or eliminate the expected profits.
• Transaction costs: Profits via arbitrage strategies tend to be minimal, making them sensitive to changes in broker fees, taxes, and exchange fees. High costs can cut or eliminate profit margins.
• Liquidity risk: While arbitrageurs provide market liquidity, they are susceptible to liquidity risk. Slippage in trades can occur, making it difficult for the arbitrageur to close out positions on time, potentially causing losses.
• Model risk: As the LTCM example above showed, statistical arbitrage in particular, given its reliance on mathematical models, introduces the risk that the models are flawed or fail to account for extreme or changing market conditions.
• Regulatory and legal risk: Changes in the law and regulations can affect arbitrage strategies, particularly for cross-border transactions.

Note

The foreign exchange (forex) market, where currency arbitrage is common, has an average daily trading volume of over $8 trillion. This makes it the largest financial market in the world.

Legal and Ethical Considerations

Arbitrage operates within a complex and varying set of legal frameworks. While arbitrage is generally seen as legal and as contributing to market efficiency and liquidity, arbitrage activities are subject to regulations and securities laws to ensure compliance with market rules and prohibit illegal activities such as insider trading and market manipulation.

Regulators like the U.S. Securities and Exchange Commission (SEC), the Commodity Futures and Trading Commission, and the Financial Conduct Authority in the U.K. enforce rules and regulations, ensuring that arbitrageurs operate within a fair and transparent environment.

Ethical considerations of arbitrage strategies focus on fairness, particularly in how advanced technologies like HFT can create unequal access to market prospects, disadvantaging smaller participants.

In addition, the potential for market manipulation through deceptive practices or the exploitation of regulatory loopholes raises regulatory concerns. These types of actions, although legal, can undermine market integrity and erode trust among market participants, highlighting the need for ethical vigilance in arbitrage strategies.

Indeed, regulations impact the feasibility and profitability of arbitrage strategies via increased compliance costs, restrictions on activities like short selling, and taxation differences across jurisdictions. These factors can influence the viability of arbitrage trades, requiring traders to continually adapt their strategies to stay compliant and maintain profitability.

Arbitrage in the Digital Age

The digital age has transformed arbitrage by increasing the speed, efficiency, and accessibility of trading strategies. Algorithmic trading and HFT have made it possible to executive arbitrage strategies with unprecedented speed and accuracy, primarily benefiting institutional traders who can invest in the necessary infrastructure.

At the same time, digital platforms have opened up new avenues for retail arbitrage, enabling individuals to participate in markets previously dominated by large players. However, this technological evolution has also intensified competition and reduced the profitability of some arbitrage opportunities, pushing traders to continuously rethink and attempt to advance their strategies.

How Do Regulatory Changes Impact Arbitrage Opportunities?

Regulatory changes can affect market conditions, transaction costs, and the legal environment for trading. While some regulations may create new opportunities by introducing inefficiencies or restrictions that can be exploited, others may reduce the profitability or feasibility of existing arbitrage strategies by increasing costs, restricting market access, or enhancing market transparency.

Can You Lose Money in Arbitrage?

Yes. Although pure arbitrage is billed as “no risk” and the price differences are typically very small, arbitrage still has drawbacks. Traders still face execution risks, counterparty risks, and liquidity risks.

How Does Arbitrage Contribute to Market Efficiency?

Arbitrage is a key mechanism through which markets achieve efficiency. By eliminating price discrepancies, aligning the prices of related securities, providing liquidity, and correcting mispricings quickly, arbitrageurs help ensure that security prices reflect all available information. This process not only stabilizes markets but also facilitates more accurate pricing of risks and returns, benefiting all market participants and contributing to the overall health and efficiency of the global financial system.

What Are the Most Common Pitfalls in Arbitrage Trading for Beginners?

Some pitfalls include underestimating all the transaction costs, execution and liquidity risks, and regulatory constraints. Having outdated information and overleveraging are other common pitfalls. Successful arbitrage requires careful planning, access to advanced technology, a thorough understanding of market dynamics, and the ability to manage risks effectively.

The Bottom Line

Arbitrage exploits price discrepancies across different assets or related securities to secure a riskless profit. While arbitrage can take various forms, such as spatial, statistical, and merger arbitrage, each type relies on the same core principle.

However, the potential profits from arbitrage must be carefully weighed against associated costs, including transaction fees, taxes, and execution risks, all of which can erode the expected returns. Despite these challenges, arbitrage remains an important mechanism for improving market efficiency and aligning prices across the financial markets.

Read the original article on Investopedia.