Arbitrage - Explained
What is Arbitrage?
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What is Arbitrage?
Arbitrage refers to subsequent buying and selling of the same type of asset in different markets to benefit from the variety in prices which each market offers. Each market tags a different price to the same or similar assets, making it more appealing to the investor or company. The imperfectly competitive nature of markets is the main reason for the existence of arbitrage. In a perfect competition, all producers must supply at a fixed price.
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How does Arbitrage Work?
Arbitrage, which is a necessary force in the market, is the act of buying assets in a market and immediately selling them off in another market at a higher price. Arbitrage exists when there are different market efficiencies, and the margin error is usually small. However, with the advent of technology, traders across different markets are able to know what each market offers for a particular product. This way, using arbitrage becomes harder. However, since these prices are not checked frequently, investors still have a chance of buying and selling off with a profit, provided it is done immediately, possibly within a matter of seconds or minutes.
Example of A Simple Arbitrage
Arbitrage can be explained in a concise manner using the example given below. Let us assume that a particular Stock CSX is trading at $10.20 on the New York Stock Exchange while trading at $10.00 at Nasdaq at the same time. Now, a trader who discovers this loophole exploits it by buying shares of CSX from Nasdaq at $10, and selling them immediately at $10.20 on the NYSE, thus bagging him or her a profit of $0.20 per stock. This will probably continue till of the stock exchange markets adjusts their price to meet the others, or till Nasdaq runs out of stock CSX in its inventory.
Example of a Complex Arbitrage
In analyzing a complex arbitrage, we shall look at the triangular arbitrage. Though not the most complicated type of arbitrage, it is much more complex than the simple one stated above. In a triangular arbitrage, an individual might choose to convert his or her currency to another in a bank. After that, he or she will proceed with the new currency to a second bank and convert it to another currency. Next, he or she proceeds to a third bank with the new currency and changes it to the first currency, with profits. If the same bank is used, it would have the information of the individual and will adjust its exchange rate to make sure that the individual goes home with what they came with. Thus, this person deems it best to visit a different bank to convert one currency to another. Assuming that the individual starts with $5 million. He or she visits three banks A, B, and C, who all have the following exchange rates
- Bank A : USD to EUR = 0. 894
- Bank B: EUR to KWD = 0.34
- Bank C: KWD to USD = 3.3
Using the rates above, youll first convert the $5 million to euros at 0.894, thus giving you 4,470,000 euros. Now, youll take that amount to Bank B and convert it to Kuwaiti Dinar at 0.34 dinar for a euro. This would give you 1,519,800 KWD. Next, youll visit Bank C and convert the KWD to USD at 3.3 dollars per dinar. This would give you 5,015,340 USD. In this case, the extra $15,340 becomes your risk-free arbitrage.
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