What is Arbitrage?

Definition: The practice of purchasing an asset at a certain price, and then reselling it for a higher price in a different market.

Arbitrage involves taking advantage of a price variance across more than one market. The term is most commonly applied to financial investment trading of assets such as bonds, stocks and derivatives, but can be applied to any situation where one can match deals that capitalize on the imbalance of market prices by purchasing and reselling assets in an effort to generate profit.

Inefficiencies in the market result in arbitrage. The practice of arbitrage in turn helps ensure that prices across markets do not stray significantly from their fair value for very long.

Those who practice arbitrage are referred to as arbitrageurs: usually arbitrageurs are banks or brokerage firms, but can also be private companies or individuals.

Arbitrage in the 21st century

Due to advanced technologies, it is very difficult these days to make a profit from arbitrage due to mispricing in the market. This is because most companies have monitors to track variations in their financial instruments and products, allowing them to correct inefficient pricing setups immediately, therefore eliminating the opportunity for arbitrage.

Negative arbitrage

On the other hand, negative arbitrage occurs when the act of arbitrage results in a lost opportunity – particularly when it comes to financial investments.

For example: if a company sells $30 million bonds that pay a 6% interest rate, and then reinvests that $30 million at 5% (because they are unable to get a higher rate for some reason) then they will lose 1% in interest that could have been retained or earned. This is considered a lost opportunity – or negative arbitrage – because the reinvested funds are earning less interest than what they need to pay back to their debt holders.