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Arbitrage is a trading strategy that is used to generate a guaranteed profit from a transaction that requires no commitment of capital or risk bearing on the part of the trader. An arbitrageur is a person who engages in this kind of trading. Arbitrage can be done when equivalent assets or combinations of assets sell for two different prices.
When the opportunity for arbitrage arises, arbitrageurs exploit that opportunity as long as it generates a profit. A simple example of an arbitrage trade would be the simultaneous purchase and sale of the same security in different markets at different prices. Another example would be cross-rate arbitrage transactions in a foreign currency market, in which three currencies are purchased and sold in different markets to exploit mispricing in the cross-exchange rate.
A third example involves the put-call parity relationship in options markets. A put is an option granting the right to sell the underlying asset at a predetermined price (the exercise price) at or before a predetermined date (the maturity date). A call is similar to a put except that it grants the right to buy. With the same underlying asset, exercise price, and maturing date, prices of European-style put options and call options should have a parity relationship in which owning a call option is equivalent to owning a put option, owning the underlying asset, and selling a risk-free bond that matures on the option’s expiration day with a face value equal to the exercise price of the option. If the prices do not conform to put-call parity, an arbitrage strategy can be applied to sell the overpriced instruments and buy the underpriced instruments simultaneously, generating a guaranteed profit that is equal to the amount by which the put or call option is mispriced.
In practice, besides the requisite information, arbitrageurs deal with market imperfections such as transaction costs and limitations on short selling to generate arbitrage profit. If an opportunity is profitable after the full transaction costs have been paid, it is considered pure arbitrage. The arbitrage trade forces the prices of the overpriced assets and the underpriced assets to reach an equilibrium that eventually eliminates the opportunity to generate an arbitrage profit. When there are market imperfections, that equilibrium usually provides boundary conditions that prevent arbitrage opportunities. The principle that no arbitrage opportunities should be available for any significant length of time is one of the elementary principles of derivative pricing. Theoretical boundary conditions of derivative pricing conform to models that assume no arbitrage. That is, the price of a derivative instrument can be modeled on the return of a synthetic portfolio, which is an appropriate combination of the underlying asset and the risk-free asset constructed to replicate the derivative instrument.
Arbitrage profits are examples of abnormal returns and are violations of the principle of market efficiency. In efficient markets arbitrage opportunities are nonexistent or are eliminated quickly. Arbitrage trade facilitates flows of market information. It also forces efficiency in intertemporal resource allocation because arbitrage transactions usually take place over a period of time. The rule of no arbitrage is upheld only if arbitrageurs are vigilant in finding arbitrage opportunities.
- Chance, Don M. 2003. Analysis of Derivatives for the CFA Program. Charlottesville, VA: Association for Investment Management and Research.
- Kolb, Robert W. 2000. Futures, Options, and Swaps. 3rd ed. Malden, MA: Blackwell.
- Reilly, Frank K., and Kenneth C. Brown. 2000. Investment Analysis and Portfolio Management. 6th ed. Cincinnati, OH: South-Western/Thomson Learning.
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