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The Idea of Economic Arbitrage Defined

Posted on | November 30, 2011 | No Comments

In economics, investment and sports, arbitrage  is the practice of taking advantage of a cost difference between two or more markets: striking a combination of matching deals that take advantage upon the asymmetry, the profit being the differences within market prices.

When used by academics, an arbitrage can be described as transaction that needs no damaging cashflow at any probabilistic or temporal state including a positive cash flow in one or more state; in simple terms, it is the potential for a risk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, such as statistical arbitrage, this could reference anticipated profit, though losses may happen, and in practice, there are always risks in arbitrage, some minor (including change of prices decreasing income), some major (for example devaluation of the currency or derivative).

In academic use, an arbitrage involves benefiting from variations in price of a single asset or identical cash-flows; in common use, it is usually used to focus on differences between equivalent assets (relative value or convergence trades), for example merger arbitrage.

Those who take part in arbitrage are known as arbitrageurs perhaps a bank or brokerage firm. The word is principally ascribed to trading in financial instruments, like bonds, stocks and shares, derivatives, goods and currencies.

Specific sport arbitrage has also recently become practical mainly because of the availability of online bookmakers supplying widely diverging odds on sports creating situations where it’s possible to place bets that cannot lose.

Although this involves bookmakers it’s not gambling as there is absolutely no risk to the initial stake which can’t be lost. This is known as ‘Arbitrage Betting‘ or ‘Matched Betting

Arbitrage isn’t simply the act of buying an item within a market and selling it in another for a higher price at some later time. The dealings must take place simultaneously to avoid exposure to market risk, or even the risk that prices may change in one market before both transactions are finished.

In functional terms, this can be generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of your trade is executed the prices sold in the market could possibly have moved.

Missing one of the legs of the trade (and subsequently having to trade it immediately after at a worse price) is called ‘execution risk’ or more specifically ‘leg risk’.

“True” arbitrage necessitates that there be no market risk concerned.

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