Financial markets are quite complex because many factors are involved when it comes to pricing of financial instruments and since financial markets are not fully efficient the price of financial instrument is not same in different markets which gives scope to market participants profiting from price difference and this act of market participants taking advantage of price difference is called arbitrage. Arbitrage in simple words refers to the simultaneous purchase and sale of an asset which is trading at a different price in different markets so as to profit from price difference of the same asset in two different markets. In order to understand more about arbitrage, one should look at various features of arbitrage –
Arbitrage Features
Identical Asset
The first and foremost characteristic of arbitrage is that assets should be identical and not different because one cannot use this strategy if assets are different. Hence for example, if the price of 1 unit of cotton in California is $100 and in Texas, it is $105 then one can carry out arbitrage strategy by buying cotton from California and selling it in Texas for a profit of $5 per piece of cotton.
Price Difference should be Substantial
Another important feature is that price difference at two different places should be substantial so that arbitrageur can profit because if the price difference is not much than transactions cost of executing a trade and other miscellaneous expense would result in no profit for arbitrageur. Hence in the above example if the price of 1 unit of cotton in California is $100 and in Texas, it is $101 than price difference is only $1 and if transactions costs and other expenses are considered than it may not be a profitable trade for arbitrageur.
Different Market
Markets should be different because the price of the financial instrument in the same market cannot be different, hence in the above example price of cotton within the California area will remain more or less same and an arbitrageur has to operate in different markets if he or she wants to profit from this strategy as dealing in the same market will not yield any returns to the arbitrageur.
Short Time Period
The price difference of the same asset in two different markets is for short period of time because arbitrageurs will spot the difference and price difference will vanish once arbitrageur starts trading in two different markets having a price difference. Hence in the above example when arbitrageurs start buying from California market it will lead to more demand resulting in an increase in the price of cotton in California market and since arbitrageurs will sell cotton in Texas market it will lead to more supply which will push the price of cotton downward in Texas market. Hence eventually the price of cotton in both California and Texas market will converge leading to no scope of profit for arbitrageurs.
Better Price Discovery
It helps in better price discovery of an asset because in the absence of arbitrage one market will have excess price benefitting the producers of goods and other markets will have lower price benefitting the consumers of goods. Hence in the above example if there are no arbitrageurs than people of California will be paying less price than normal price for 1 unit of cotton resulting in a loss for producers of cotton while the people of Texas will be paying more price than normal price for 1 unit of cotton resulting in a loss for consumers of cotton.
As one can see from the characteristics of arbitrage that it is a very sophisticated trade and requires considerable market expertise as well as speed in carrying out the trade on the part of the person doing arbitrage.