With foreign exchange investments, the strategy known as arbitrage lets traders lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency across two different markets. This move lets traders capitalize on the differing prices for the same asset in the two disparate regions on either side of the trade.
Key Takeaways
- Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market for a higher price.
- The temporary price difference of the same asset between the two markets lets traders lock in profits.
- Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn't yet been adjusted for the fluctuating exchange rate.
- An arbitrage trade is considered to be a relatively low-risk exercise.
What Is Arbitrage?
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. The arbitrage strategy can be used in many markets, including those for trading stocks and those for currency trading.
In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign exchange where the equity's share price has not yet adjusted for the exchange rate, which is in a constant state of flux. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange. This difference positions the trader to harvest gains from this differential.
Although this may seem like a complicated transaction to a beginner, arbitrage trades are quite straightforward and are considered low-risk.
Example of Arbitrage
Consider the following arbitrage example:
TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). First, let's assume the stock trades for $63.50 CAD on the TSX and $47.00 USD on the NYSE. Next, assume the USD/CAD exchange rate is $1.37—meaning that one U.S. dollar equals $1.37 CAD. So, using our share prices from the two markets, the $47 USD share should equal $64.39 CAD on the TSX. But it does not; the current price on the Toronto exchange is less.
Under this set of circ*mstances, a trader can purchase TD shares on the TSX for $63.50 CAD and simultaneously sell the same security on the NYSE for $47.00 USD. Taking the exchange rate into consideration, the equivalent value of each share should be $64.39 CAD. Ultimately the trader yielded a profit of $0.89 per share ($64.39 – $63.50) for this transaction.
Beware of Transaction Costs
When contemplating arbitrage opportunities, you must consider transaction costs, because if they're too high, they will neutralize the gains from those trades. For instance, in the scenario mentioned above, if the trading fee per share exceeded $0.89, it would nullify any profits.
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.
Is Arbitrage Legal?
Yes, arbitrage is legal in the U.S. Many investors like this type of trading because it provides liquidity and encourages market efficiency by identifying price discrepancies and fostering price convergence.
Can You Lose Money in Arbitrage?
You can lose money in arbitrage. Although pure arbitrage should be no-risk and the price differences are typically very small, there are still some limits to arbitrage. Traders still face execution risk, counterparty risk, and liquidity risk in trading.
What Makes Arbitrage Low-Risk?
Pure, "textbook" arbitrage is considered low- (or no-) risk because it doesn't involve additional capital; it's merely buying in one market and selling in another. And, since the price difference is so low, the amount risked is usually low, too. However, arbitrage in the real world usually entails large-volume trades as well as leveraged capital, timing variations, and other factors that increase risk.
The Bottom Line
If all markets were perfectly efficient, and foreign exchange ceased to exist, there would no longer be any arbitrage opportunities. But markets are seldom perfect, which gives arbitrage traders a wealth of opportunities to capitalize on pricing discrepancies.
FAQs
Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.
What is arbitrage with an example? ›
An example of arbitrage is when somebody buys a stock on one exchange for ten dollars and immediately sells it on another exchange for eleven dollars. The person has made a profit of one dollar without having to put any money at risk. This is possible because the two exchanges had different prices for the same stock.
What is cost arbitrage? ›
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share.
Which of the following is an example of arbitrage? ›
An example of arbitrage is "Roger buys a car in the US and brings it to Australia to sell at a much higher price". Arbitrage is a method of buying and selling of goods at different prices in different markets.
Why is arbitrage illegal? ›
Arbitrage trades are not illegal, but they are risky. Arbitrage is the act of taking advantage of a discrepancy between two almost identical financial instruments. These are typically traded on different financial markets or exchanges. It happens by buying and selling for a higher price somewhere else simultaneously.
How do arbitrage make money? ›
Retail arbitrage is the practice of buying a product at a low price from a retail store and reselling that same item for a higher price on an online marketplace such as Amazon. As the seller, you are taking advantage of the price difference between two markets, and making a profit.
What are the two types of arbitrage? ›
Types of Arbitrage
- Pure Arbitrage: The arbitrageur makes a buy or sells decision right away, without having to wait for funds to clear.
- Retail Arbitrage: This is a popular e-commerce activity. ...
- Risk Arbitrage: ...
- Convertible Arbitrage: ...
- Merger Arbitrage: ...
- Dividend Arbitrage: ...
- Futures Arbitrage:
For example, if the fair market value of stock A is determined, using the APT pricing model, to be $13, but the market price briefly drops to $11, then a trader would buy the stock, based on the belief that further market price action will quickly “correct” the market price back to the $13 a share level.
What things can I arbitrage? ›
Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader.
What is the secret of arbitrage? ›
Arbitrage is like a secret way to make money in the financial world. It's about finding opportunities when prices are not quite right and making a profit from them. Whether it's through spatial, temporal, statistical, merger, risk, or convertible arbitrage, people quietly use these strategies to make money.
Arbitrage – whether online or retail – is essentially the same as flipping. Retail arbitrage is when you buy items from local stores and retail shops to flip on Amazon for a profit.
Is it a good idea to arbitrage? ›
Arbitrage, at its core, is important for narrowing the price differences between identical or similar assets — typically stocks, commodities and currencies. Arbitrage helps to make the financial markets more efficient by eliminating price differences. Investors can benefit from this by achieving low-risk yields.
Is arbitrage good or bad? ›
Arbitrage, at its core, is important for narrowing the price differences between identical or similar assets — typically stocks, commodities and currencies. Arbitrage helps to make the financial markets more efficient by eliminating price differences. Investors can benefit from this by achieving low-risk yields.
What is an example of arbitrage on Airbnb? ›
Airbnb Rental Arbitrage Example
Let's say you rent a house on a long-term lease for $2,500 per month. Subletting the same house as an STR at a rate of $200 per night could earn you more than you pay in rent—in less than two weeks. Any further STR income within the month would be profit for you, minus expenses.
Is arbitrage still possible? ›
Despite the disadvantages of pure arbitrage, risk arbitrage is still accessible to most retail traders. Although this type of arbitrage requires taking on some risk, it is generally considered "playing the odds." Here we will examine some of the most common forms of arbitrage available to retail traders.
