What is arbitration?

Answer:

Arbitrage is basically buying securities in one market and simultaneously selling it in another market at a higher price, the benefit from the temporary difference in prices. It is considered to be a risk-free profit for the investor/trader.

In the context of the stock market, traders often try to use arbitrage opportunities. For example, a trader may buy shares on foreign exchanges, where prices have not yet adjusted to the constantly changing course. So, the stock price on the currency undervalued compared to the price of local exchange, and the trader can profit from this difference.

Here is an example of arbitrage opportunities. TD Bank (TD) trades on the Toronto stock exchange (TSX) and the new York stock exchange (NYSE). For example, TD is traded at CAD63.50 on the TSX and USD47.00 on the NYSE. The EUR/USD is 1.35, which means that US $ 1 = CAD1.37. Given this course, USD47 = CAD64.39. It is clear that there is an opportunity for arbitrage here, given the exchange rate, etc are evaluated differently in both markets. A trader can purchase TD shares on the TSX for CAD63.50 and sell the same securities on the NYSE for USD47.00 (equivalent to CAD64.39), netting them CAD0.89 per share (64.39 – 63.50) for the transaction.

If all markets are perfectly efficient, then there would be no arbitrage opportunities — but markets seldom remain perfect. It is important to note that even when markets have a discrepancy in pricing between two equal goods, there exists the possibility of arbitrage (more on market efficiency, see our article “what is market efficiency?”)

Transaction costs can turn arbitrage situation that has no benefit for the investor. For example, consider the situation with TD Bank shares higher. If the trading fee per share or a total value of more than the total arbitrage return arbitrage will be erased.

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