Arbitrage is the process of exploiting price differences of identical or similar financial instruments across different markets. The aim of an arbitrageur is to make riskless profits by buying low in one market and selling high in another market, taking advantage of price discrepancies.
The concept of arbitrage is based on the efficiency of the market. If a financial instrument is mispriced due to any reason such as inefficient information dissemination or human emotions, an arbitrageur can profit by correcting the price discrepancy. This process of profit-making attracts other traders to buy or sell the instrument, leading to an increased demand/supply, and eventually, the price discrepancy is corrected. Thus, arbitrage contributes to the efficient pricing of assets in the market.
There are several types of arbitrage such as:
1. Spatial arbitrage: This is a type of arbitrage where an asset is bought in one location and sold in another location where the price is higher. For example, if crude oil is priced lower in one country than in another, a trader could buy crude oil in the cheaper country and sell it in the more expensive country, making a profit on the price difference.
2. Temporal arbitrage: This is a type of arbitrage where an asset is bought at a lower price and sold at a higher price in the same market but at different times. For example, if an investor expects the price of a stock to increase in the future, he could buy the stock now and sell it later for a profit.
3. Statistical arbitrage: This is a type of arbitrage where trading strategies are developed based on the statistical analysis of price movements and correlations between financial instruments.
The presence of arbitrage opportunities in the market contributes to price efficiency since traders would buy or sell assets to correct price discrepancies. As a result, arbitrage helps to ensure that assets are priced fairly in the market, which is critical for maintaining investor confidence and market stability. However, it is important to note that arbitrage opportunities are often short-lived, given that traders would quickly take advantage of them, which would correct the price discrepancy.