The concept of arbitrage carries a significant degree of importance in the field of economics and finance. According to the theory of finance and economics, arbitrage is the method of fetching the benefit of a price derivative or a price differential existing in a number of markets.
In case of arbitrage, a collection or group of corresponding transactions is chanced upon capitalizing on the disequilibrium and profit arises from the variation in market prices. According to the academicians, an arbitrage refers to a deal where there is no involvement of a negative cash flow whether in a temporal state or in a probabilistic state.
As per their opinion, there is a positive cash flow in minimum one state. In order to simply define, an arbitrage is basically a risk-free profit or gain. The person who is involved in arbitrage transactions or performs arbitrage transactions is known as an arbitrageur.
The concept of arbitrage and the term arbitrage are primarily implemented in the buying and selling of financial instruments, for example stocks, bonds, commodities, derivatives, as well as currencies or foreign exchange.
If there is a condition that no profit could be made out from arbitrage transactions, then that condition is known as an arbitrage-free market or arbitrage equilibrium. All the prices existing in that market are responsible for forming such a condition. An arbitrage equilibrium or arbitrage-free market functions as a prerequisite for a general economic equilibrium.
The stipulation that there is no presence of arbitrage is utilized in the field of quantitative finance for the computation of a distinct risk neutral price for differentials or derivatives. A statistical arbitrage refers to disequilibrium in anticipated values.
Arbitrage only takes place when one of the three following conditions are satisfied:
The same financial instrument is not traded at equal prices in every market. This condition is known as the law of one price.
Two financial instruments that have similar cash flows are not traded at equal price.
A commodity, which has a fixed price in the future, is not traded at the present time at a risk free interest rate and future discounted price. Here the commodity has no insignificant storage expenditure. This condition is mostly applicable for food grains; however, it is not applicable for securities or stocks.
The different types of arbitrage can be categorized into the following:
Exchange-traded fund arbitrage
Merger arbitrage or risk arbitrage
Convertible bond arbitrage
Municipal bond arbitrage
Last Updated on : 1st July 2013