Arbitrage is the process where there is simultaneous purchase and sale of an asset in order to profit from a difference in the price of the similar financial instruments, on different markets or in different forms. A person who engages in this type of trading is called an arbitrageur. The term is applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and also currencies. Just an act of buying a product in one market and selling it in another for a higher price at some later time is not arbitrage. Arbitrage is when the transactions occur simultaneously to avoid exposure to market risk, or the risk assumed that prices may change in one market before both transactions are complete. In practical terms, this is only possible with securities and financial products which can be traded electronically.
For example; this type of price arbitrage is very common, but it ignores the cost of transport, storage, risk, and other factors. "True" arbitrage is when there is no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one exchange and selling on the other.
Arbitrage is possible when any one of the below three conditions is met:
- The same asset should trade at the different price on all markets
- Two assets with identical cash flows should not trade at the same price.
- An asset having a known price in the future does not trade today at its future price discounted at the risk-free interest rate.
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Anees
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