Glossary
Arbitrage
Profiting from a price difference for the same or equivalent asset in two places by buying the cheap one and selling the dear one.
On this page
Arbitrage is buying an asset in one market and simultaneously selling the same or an economically equivalent asset in another to capture a price difference between them. In its pure textbook form it is riskless, because both legs happen at once. Arbitrage matters even to people who never do it: the competition among arbitrageurs is what keeps prices of identical things aligned across exchanges, currencies and fund wrappers.
How it works
Everyday examples include:
- ETF creation and redemption. Large firms called authorized participants exchange baskets of stocks for ETF shares (or the reverse) whenever an ETF's price drifts from its net asset value, pulling the two back together.
- Index futures versus the underlying stocks, linked by interest rates and dividends.
- Currency triangles, where three exchange rates must be mutually consistent.
"Arbitrage" that carries risk
The word is often stretched to strategies that are not riskless. Merger arbitrage buys a takeover target below the agreed deal price and profits if the deal closes, but loses heavily if it collapses. Statistical arbitrage bets that historically related prices will converge again. These trades can and do lose money, sometimes in large, crowded unwinds.
For individual investors the lesson is mostly about efficiency: obvious, risk-free price gaps in liquid markets are almost always closed by professionals with faster systems and lower costs.