Arbitrage is the purchase or sale of any financial instrument and the simultaneous taking of an equal and opposite position in a related market, in order to take advantage of small price differentials between markets. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.
Arbitrage has existed in various forms probably since the beginning of time, but in modern times it is now mainly associated with financial markets.
A person who engages in arbitrage is called an arbitrageur- such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.
Arbitrage has been regarded as the “holy grail” of the capital markets and options arbitrage certainly is the holy grail of free profits for the privileged options traders in options trading. If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market.
Currency arbitrage opportunities arise when currency prices go out of sync with each other. There are numerous forms of arbitrage involving multiple markets, futures deliveries, options, and other complex derivatives.
Arbitrage describes a transaction that can be set up with zero outlays and a sure profit, unambiguously a “free lunch.” For example, if 100 yen are selling in Miami for $1.00, but $1.00 simultaneously costs 99 yen in Tokyo market, arbitrage would obviously be possible if there are no trading costs; you could arrange to sell 99 yen in Tokyo, receive a dollar ($1.00), and buy 100 yen in Miami, paying the dollar.
From the above example the transaction costs nothing and nets one (1) yen. Even on a good day no one will be this lucky, and arbitrage opportunities, if they exist at all. Are likely to be fleeting and a good deal will be more complicated. More complicated foreign exchange arbitrages, such as the spot-forward arbitrage are much more common. Arbitrage helps to keep the value of a commodity or currency consistent worldwide. The activity of other arbitrageurs can make this risky. Arbitrage is recommended for experienced investors only.
Economists use the term “global labor arbitrage” to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization.
Sports arbitrage - numerous internet bookmakers offer odds on the outcome of the same event. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the ‘palpable error’ rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds.
Exchange-traded fund arbitrage - Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse.
As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. More generally, international arbitrage opportunities in commodities, goods, securities and currencies, on a grand scale, tend to change exchange rates until the purchasing power is equal.
At the heart of the Arbitrage philosophy is the belief that a man must capitalize on opportunities and take calculated risks in order to be successful. In the end, we all must engage in Arbitrage. ” In this sense, any trader who buys something in one market whether it is a commodity like grain, financial Securities such as stock in a company, or a currency such as the Japanese yen and sells it in another market at a higher price is engaged in arbitrage. In economic theory, arbitrage is a necessary activity in any market, helping to reduce price disparities between different markets and to increase a market’s liquidity (ability to buy and sell).
Triangular arbitrage is a trading strategy involving placing three concurrent trades in three markets in an attempt to profit from imbalances between the markets. Triangular arbitrage forces the cross-rates to be internally consistent.
As indicated above, triangular arbitrage is a specific trading strategy that involves three currencies, their correlation, and any discrepancy in their parity rates. Thus, there are no arbitrage opportunities when dealing with just two currencies in a single market. Their fluctuations are simply the trading range of their exchange rate. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Triangular arbitrage among currencies, once only a theory, is now common practice for those with access to large amounts of money.
Using triangular arbitrage strategies on forex market has one salient advantage: Predetermined profits can be realized if the trades are executed smoothly. Unfortunately, the disadvantages of this strategy are numerous: (1) Higher Transaction Costs, (2) Higher margin requirements, (3) Precision timing is required, (4) Complexity and Advanced monitoring techniques are usually required.
This article is strictly for informational proposes and does not provide individual, customized investment advice. The money you allocate to futures or forex should be strictly the money you can afford to risk.