Arbitrage

Arbitrage is the practice of taking advantage of price differences for the same asset or closely related assets across different markets or forms, in order to realize a risk-free profit. In theory, arbitrage involves simultaneous or hedged transactions that lock in a positive payoff with no net investment. In practice, opportunities are short-lived and can entail execution risk, funding costs, settlement risk, and bid-ask spreads, so the net profit must exceed these costs.

Common forms include spatial or locational arbitrage, where an asset is bought where it is priced lower and sold where it is priced higher; triangular arbitrage in foreign exchange, which exploits inconsistencies among three currency pairs; and covered interest rate arbitrage, which involves borrowing in one currency, converting, and using forward contracts to lock in a risk-free rate differential.

In commodities and securities markets, carry or basis arbitrage exploits price differences between spot and futures prices, or between related instruments. Statistical arbitrage refers to algorithmic strategies that seek to exploit short-term mispricing but may involve residual risk; it is not strictly risk-free.

Arbitrage helps enforce price consistency and underpins several financial theories. The law of one price posits that identical assets should trade at the same price, while the efficient market hypothesis implies that available arbitrage opportunities should be rapidly eliminated. More formal frameworks, such as arbitrage pricing theory, model asset prices as driven by multiple risk factors and treat mispricing as temporary.

Arbitrage opportunities are typically more common in liquid, well-connected markets and diminish as technology and competition improve execution speed and regulation.