The Idea of Economic Arbitrage Defined

In economics, finance and sports, arbitrage  is the method of taking advantage of a cost difference between 2 or more markets: striking a variety of matching deals that capitalize upon the imbalances, the gain being the gap amongst the market prices.

When employed by academics, an arbitrage can be described as transaction which involves no bad cashflow at any probabilistic or temporal state as well as a positive income in a minimum of one state; in simple terms, it’s the possibility of a risk-free profit at zero cost.

In principle and within academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, this could relate to predicted profit, though losses may arise, and in practice, there are always risks in arbitrage, some minor (for example change of prices decreasing profit margins), some major (for instance devaluation of the currency or derivative).

In academic use, an arbitrage involves taking advantage of variations in price of a single asset or identical cash-flows; in common use, it is usually used to mean differences between equivalent assets (relative value or convergence trades), as in merger arbitrage.

Those who take part in arbitrage are called arbitrageurs possibly a bank or brokerage firm. The word is mainly related to trading in financial instruments, including bonds, stocks, derivatives, commodities and currencies.

Sports arbitrage has additionally recently become possible because of the accessibility to web-based bookmakers providing widely diverging odds on sporting events creating situations where it is possible to place bets that cannot lose.

Although this involves bookmakers it’s not gambling as there is absolutely no risk on the initial stake which can’t be lost. This is called ‘Arbitrage Betting‘ or ‘Matched Betting‘

Arbitrage isn’t simply the act of buying a physical product in a single market and selling it in another for a better price at some later time. The transactions must happen simultaneously to protect yourself from exposure to market risk, or even the risk that prices may change in one market before both transactions are complete.

In realistic terms, this can be generally only possible with securities and financial products that may be traded electronically, and even then, when each leg of the trade is carried out the prices in the market could possibly have moved.

Missing one of the legs from the trade (and subsequently having to trade it soon after at a worse price) is known as ‘execution risk’ or more specifically ‘leg risk’.

“True” arbitrage mandates that there be no market risk concerned.