Arbitrage is a financial strategy that consists of taking advantage of the price difference between different markets on the same financial asset to obtain an economic benefit, usually without risk.
To perform arbitrage, complementary operations (buy and sell) are carried out at the same time and wait for prices to adjust. Arbitrage takes advantage of that divergence and makes a risk-free profit. In other words, the arbitrageur positions himself short (sell) in the market with the highest price and long (buy) in the market with the lowest price. The benefit would be given by the difference between the two markets.
Arbitrage is possible due to inefficiencies in the markets. When there is no possibility of doing so, the condition of non-arbitration is said to be fulfilled. The more efficient a market is, the more difficult it will be to do so.
Arbitration is considered risk free. However, if the difference is due to an inefficiency such as liquidity, it is possible that this liquidity does not allow us to take advantage of the price difference or that to take advantage of it we are assuming the risk of price variation and therefore we are not really arbitrage.
In which markets can arbitrage be done?
The different markets in which this strategy can be carried out are:
- Markets located in different places: For example arbitration between Frankfurt and Madrid or Chicago.
- Different types of markets: For example, derivatives market and spot markets.
The stock trading tends to regulate the markets, since when selling in the market with the highest price they generate an increase in supply that causes the price to fall and when buying in the market with the lowest price they generate an increase in demand that makes the price increases ( law of supply and demand ).
This rise and fall in price continues until the moment in which it is no longer profitable to do this type of operation. That is, when the price of both markets is equal and therefore in equilibrium.
Types of arbitration
We can distinguish several types of arbitration:
- Two-point arbitrage: This is the difference between the prices of two markets directly.
- Three-point arbitration or triangular arbitration: In this case, it is necessary to use three markets. The difference between two markets is imperceptible, but when taking it to a third market it becomes higher. For example, the difference between three currency pairs, changing EUR / USD, then USD / GBP and then EUR / GBP. It is a very difficult arbitration to observe and computer tools are usually necessary to arbitrate it.
It should be noted that arbitration of three or more points can be performed. Now, given its complexity, we will ignore it in this explanation. The goal is to simply explain the concept, not delve into its difficulties.
Examples of financial arbitration
For example, suppose that the Banco Santander share is at 6 euros and the financial future of Santander at 7 euros. We would buy the Santander share on the spot market and at the same time we would sell the future price. After time, when both have adjusted, we will win the difference.
Another example, if the price of the euro / dollar in the Madrid market is 1.1 dollars per euro, but in New York it is 1.05 dollars per euro.
Assuming that we can exchange in Madrid and New York at the same time, the operation would be the following:
- I buy dollars in Madrid: For example, changing 1,000 euros to dollars, since the change is € 1 = $ 1.1, I receive $ 1,100.
- I sell those dollars in New York: I change the 1,100 dollars to euros. Since the change here is € 1 = $ 1.05, they give me 1,047.62 euros.
- I have won 47.62 euros without any risk. In other words, we have arbitrated. So we will have had a profit of 0.05 cents for each risk-free euro (not counting commissions and others). With this strategy we are regulating the market and causing the dollar price in Madrid to rise and in New York to fall, adjusting so that there are no arbitrage possibilities.
The foreign exchange market is one of the most liquid in the world and, therefore, it is very difficult to arbitrage in it. This example is exaggerated for ease of understanding.