Arbitrage
Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT
Meaning
Arbitrage means buying and selling the same asset at the same time in two markets, to profit from a gap between its prices. Both trades happen together, so the trader takes little or no risk from price movements. Arbitrage is useful to the market. When arbitrageurs buy where the asset is cheap and sell where it is dear, the two prices are pushed back into line.
Example
Cash-futures arbitrage: a share trades at one price in the cash (spot) market, and its futures contract trades at a higher price than it should. A trader buys the share in the cash market and sells the futures contract at the same time. When the contract expires, the two prices meet, and the trader keeps the gap as profit.
Don't confuse with
- Speculation: betting on which way a price will move, which carries real risk. Arbitrage profits from a price gap that already exists.
- Hedging: taking an opposite position to reduce a risk you already face, not to earn a profit.
Related concepts
- Derivatives
- Forward contract
- Futures
- Options
- Swap
- Interest rate swap
- Credit default swap
- Commodity derivatives
- Hedging
- Futures and options trading