All About Arbitrage - What is Arbitrage in Financial Terms?
Imagine an investment strategy that allows investors to take advantage of the difference in the price of a certain market or asset. In other words, the investor would profit from the discounted purchase and immediately resell of the product or share in a different market at a higher price. This investment strategy has been in practice since the concept of competing markets was first recognized. In today’s marketplace, this practice is known as arbitrage. An arbitrageur seeks out assets that exhibit certain characteristics that indicate that the market (or markets) is compatible with sustaining a reasonable profit during the exchange. In order for this to happen, one of the following three circumstances must exist: 1. An asset with a reliable future-estimated price is currently trading at a lower price than its monetary value in a market with little or no risk. 2. An asset trades in one market considerably lower than it trades in another. 3. Two different assets are traded at varying prices although the cash flow for both assets is the same. These conditions might seem a bit confusing to the everyday investor, however, arbitrage takes place daily in a number of circumstances that are fairly commonplace. For example, foreign money exchangers take advantage of the arbitrage between two currencies when they exchange one currency for another with international tourists. Another common example of arbitrage is when an individual purchases a stock in a market where the stock is undervalued and turns around and sells the stock in a foreign market where the stock is priced higher. By doing this, the trader has generated a profit through the difference in the price of the two stocks. Arbitrage occurs frequently in a variety of environments. Many businesses operate each day based solely upon its principle. Investors from both domestic markets as well as foreign markets have been taking advantage of arbitrage as an investment strategy since its popularity greatly increased during the 1980’s. Private investors who are interested in becoming arbitrageurs must keep in mind that while this technique can be a very lucrative investment option, one of the key elements to turning a profit using this approach is the ability to make a decision quickly to purchase the stock or asset in question and then turn around and resell before the market has the opportunity to equalize (therefore reducing or even eliminating the profit margin between the two markets).
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