Arbitrage
1. Broad definition
In a broad sense, arbitrage means identifying discrepancies between quoted market prices, and then dealing simultaneously in the related market instruments to earn profits free from the risk of changes in market prices.
The simplest theoretical form of arbitrage activity would be to deal simultaneously in two identical instruments at two different market prices. In practice such simple arbitrage opportunities are very rare. More commonly, arbitrage activities involve dealing in equivalent combinations of larger numbers of different instruments.
A market participant who takes advantage of arbitrage opportunities is known as an arbitrageur. Under efficient market conditions, the activities of arbitrageurs and other market players create supply and demand pressures in the market which act to eliminate temporary pricing discrepancies.
Many valuation and pricing models are based on ‘no arbitrage’ assumptions. In other words, the valuation models assume that all pre-existing arbitrage opportunities in the market have been identified and eliminated, so that it is now possible to predict the values and market prices of traded instruments by calculating them from other related market prices.
2. Narrower definition
Defined more narrowly, arbitrage means the purchase of securities in one market and the simultaneous sale of the same or equivalent securities in the same or related markets, in order to earn immediate profits from a temporary price differential within a market or between related markets.
