Arbitrage definition

Arbitrage refers to the practice of buying an asset then selling it immediately to take advantage of a difference in price.

The asset will usually be sold in a different market, different form or with a different financial instrument, depending on where the discrepancy in price occurs. Opportunities for arbitrage can occur in almost any financial instrument, including options, shares, forex, commodities or derivatives.

In stocks, for example, arbitrage can occur when a stock is listed on exchanges in two different countries. Because of a foreign exchange shift in one of the countries, the price of the share differs between the two exchanges. By simultaneously selling the stock on one exchange and buying it on the other, a trader can take advantage of the price discrepancy for immediate profit.  

True arbitrage

True arbitrage is arbitrage in its pure form, as detailed above. In essence, true arbitrage involves taking advantage of inefficiencies in the market, as it involves two assets with equal value trading at different prices. This also makes true arbitrage free of risk. The market inefficiencies that make true arbitrage possible have become increasingly rare as technology has improved.

Risk arbitrage

For that reason, riskier forms of arbitrage have increased in prominence. Risk arbitrage involves trading an asset that is currently priced at a value that will swiftly change: shares in a company subject to a takeover, for example. Unlike true arbitrage, it is not 100% risk free, as the change in value may never materialise.

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