What is Arbitration?

With currency investments, the strategy known as arbitrage allows traders to lock in their gains by simultaneously buying and selling an identical security, commodity or currency in two different markets. This decision allows traders to capitalize on the different prices for the same asset in the two disparate regions represented on either side of the trade.

Key points to remember

  • Arbitrage occurs when a security is bought in one market and sold simultaneously in another market, at a higher price.
  • The temporary price difference of the same asset between the two markets allows traders to lock in their profits.
  • Traders frequently attempt to exploit the arbitrage opportunity by buying a stock in a foreign market where the stock price has not yet been adjusted to account for fluctuations in the exchange rate.
  • An arbitrage transaction is considered a relatively low risk exercise.

What is Arbitration?

Arbitrage describes buying a security in one market and simultaneously selling it in another market at a higher price, allowing investors to take advantage of the temporary difference in cost per share. In the stock market, traders exploit arbitrage opportunities by buying a stock in a foreign market where the stock price has not yet adjusted to the exchange rate, which is constantly changing. The price of the action on the foreign exchange market is therefore undervalued compared to the price on the local market, positioning the trader to take advantage of this differential. Although it may seem like a complicated transaction to the untrained eye, arbitrage transactions are actually quite simple and therefore considered low risk.

Example of arbitration

Consider the following arbitrage example: TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). On a given day, assume the stock is trading at CAD$63.50 on the TSX and $47.00 on the NYSE. Suppose further that the USD/CAD exchange rate is $1.37, which means that $1 USD = $1.37 CAD, where $47 USD = $64.39 CAD. In this set of circumstances, a trader can buy TD shares on the TSX for C$63.50 and can simultaneously sell the same security on the NYSE for US$47.00, which equals C$64.39, generating ultimately a profit of $0.89 per share ($64.39). – $63.50) for this transaction.

Beware of transaction costs

When considering arbitrage opportunities, it is essential to consider transaction costs, because if the costs are prohibitive, they can threaten to offset the gains from these transactions. Case in point: In the scenario above, if the trading fee per share exceeded $0.89, the total arbitrage return would offset those profits.

Price differences between markets are usually minute, so arbitrage strategies are only practical for investors with substantial assets to invest in a single trade.

The essential

If all the markets were perfectly efficient and the exchange ceased to exist, there would be no more arbitrage opportunities. But markets are rarely perfect, giving arbitrage traders a wealth of opportunities to take advantage of price discrepancies.

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