Arbitrage
The simultaneous purchase and sale of equivalent assets in different markets to profit from a price discrepancy.
What is Arbitrage?
Arbitrage is the practice of simultaneously buying and selling equivalent assets in different markets or forms to capture a risk-free profit from price differences. In theory, pure arbitrage carries no risk because the positions perfectly offset each other. Classic examples include buying a stock on one exchange where it is priced lower and simultaneously selling it on another where it trades higher. In fixed income, covered interest rate arbitrage exploits deviations from interest rate parity. In practice, most real-world "arbitrage" carries some risk — merger arbitrage (buying a target after a deal is announced) carries deal-break risk. Arbitrageurs play a vital role in keeping prices consistent across markets; as they exploit mispricings, their trades eliminate the discrepancy.
Example
A simple currency arbitrage: if EUR/USD = 1.10, USD/GBP = 0.80, and EUR/GBP = 0.87, then 1 EUR should equal 0.88 GBP via the dollar (1.10 × 0.80). The EUR/GBP rate at 0.87 creates a profitable triangular arbitrage: convert €1,000,000 to $1,100,000 at 1.10, then to £880,000 at 0.80, then back to €1,010,345 at 0.87 — a $10,345 risk-free profit. Such opportunities are typically eliminated within milliseconds by algorithmic traders.