Arbitrage finance theory posits that in an efficient market, identical or near-identical assets should trade at the same price. Any deviation from this “law of one price” creates an arbitrage opportunity: a risk-free profit obtained by simultaneously buying the asset in one market and selling it in another where it is priced higher.
The core idea rests on the assumption of market efficiency. An efficient market rapidly incorporates new information into asset prices, making arbitrage opportunities fleeting. The actions of arbitrageurs, seeking to exploit these temporary price discrepancies, are crucial for maintaining this efficiency. By buying low and selling high, they drive prices towards equilibrium, eliminating the profit potential and enforcing the law of one price.
Different forms of arbitrage exist. Spatial arbitrage involves exploiting price differences across different geographic locations. For example, buying gold in London where it is cheaper and simultaneously selling it in New York where it is more expensive. Temporal arbitrage (or carry arbitrage) takes advantage of price differences over time. This might involve storing a commodity and selling it at a later date, profiting from the price difference after accounting for storage and financing costs. Triangular arbitrage involves exploiting price discrepancies in currency exchange rates between three different currencies. For instance, converting USD to EUR, then EUR to GBP, and finally GBP back to USD, aiming to end with more USD than initially invested.
Index arbitrage is another prevalent type. It involves exploiting price differences between a stock index futures contract and the underlying basket of stocks represented by the index. If the futures contract is overpriced relative to the current value of the underlying stocks, an arbitrageur could buy the stocks and simultaneously sell the futures contract, locking in a profit.
While theoretically risk-free, arbitrage in practice involves certain risks. Execution risk refers to the possibility that the price advantage might disappear before the arbitrageur can complete the transactions. Model risk arises from inaccurate models used to identify arbitrage opportunities. Liquidity risk can occur if the arbitrageur cannot easily buy or sell the assets in sufficient quantities to execute the arbitrage strategy. Finally, transaction costs, such as brokerage fees and taxes, can erode the profit margin of an arbitrage opportunity.
The effectiveness of arbitrage in maintaining market efficiency is debated. Critics argue that transaction costs, information asymmetry, and market imperfections can limit arbitrage opportunities and prevent prices from fully converging. However, the constant pursuit of arbitrage by sophisticated traders and institutions contributes significantly to price discovery and market equilibrium, making markets more efficient and reducing opportunities for risk-free profit. Arbitrage, therefore, remains a cornerstone of modern finance theory, driving price convergence and market efficiency.
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