Arbitrage refers to making profit by taking advantage of difference between the price of the same asset in different market and the person who does arbitrage is called arbitrageur.
Types of arbitrage
- Geographical – It refers to difference in price of an asset in two different markets, so for example if gold in New York is trading at 1600 dollars and gold in London is trading at 1550 (after taking into account currency factor) than there is an opportunity of making profit of 50 dollars if one buys it from London and sell in New York.
- Time Related – In this type of arbitrage an arbitrageur can make profit by trading same security for different periods of time. So for example if stock price of amazon is 50 dollar in spot market and 45 dollar in 3 month future contract then one can sell the stock in spot market and buy 3 month futures contract in order to make 5 dollar per share.
- Cross Rate – This type of arbitrage can be done only in currency market where an arbitrageur would be taking advantage of difference in exchange rates between currencies. For example if Dollar rupee exchange rate is 2 and euro rupee exchange rate is 1.5 and dollar euro exchange rate is 1.2 than an arbitrageur with 3 million dollars would first sell those dollars for 6 million rupees (3*2) and then sell 6 million rupees for 4 million (6/1.5) euro and then again would sell 4 million euro for 3.33 million dollar (4/1.2). After doing all the above transaction an individual would be able to make .33 million dollars (3.33-3).
In real life however such kind of opportunities seldom exists because majority of markets are efficient and also there are various costs associated with arbitrage like interest rate, availability of cash, exchange rate fluctuation and so on. Apart from above there are other types of arbitrage also like merger, Covered interest, fixed income and so on.