Arbitrage is an important type of investment strategy.

What is Arbitrage

Arbitrage is, at heart, a simple concept; it means taking advantage of price differences in different markets, so that you can buy in one market and sell in the other for a profit. Since this is a risk-free way of making money, investors will leap on the opportunity and arbitrage the advantage away (i.e. as people start to buy and sell the price difference will disappear). Hence, arbitrage opportunities may be short-lived. In the business press, arbitrage almost always refers to arbitrage involving financial instruments.

Financial Arbitrage in Practice

Since true arbitrage is easy money, it is obvious that not many cases will exist for long. A difference in price for the same stock on two markets will almost instantly be arbitraged away. However, smart financial wizards are always trying to find portfolios of assets that give an arbitrage opportunity. For example, they might find some particular combination of foreign bonds and currency futures that they feel gives them a low-risk opportunity to arbitrage. Notice the difference from the more usual speculative investing. In speculative investing, you are betting that a certain asset will increase (or decrease) in value. In arbitrage, you think you have spotted a subtle market inefficiency that can be exploited. In practice, complex arbitraging schemes using a variety of related financial instruments may be risky. In fact, the very complexity of the schemes can conceal the risk.

Arbitrage as a Fashionable Term

Arbitrage is such a cool word that marketers like to use it whenever they can, whether or not the underlying activity really is arbitrage.

What HR Needs to Know

• Aribtrage is a fashionable term, that is often misused.
• Simple risk-free arbitrage opportunities rarely exist.
• Complex arbitrage may be more risky than it appears.

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