Arbitrage refers to the subsequent buying and selling of the same asset type in different markets in order to take advantage of the variation in prices offered by each market. Each market charges a different price for the same or similar asset, making it more attractive to investors or companies. The imperfectly competitive nature of the market is the main reason for the existence of arbitrage. In perfect competition, all producers must supply at a fixed price.
Arbitrage, which is an important force in the market, is the act of buying an asset in a market and immediately selling it on another market for a higher price. Arbitrage occurs when there are different market efficiencies, and the margin error is usually small. However, with advances in technology, traders in different markets can find out what each market has to offer for a particular product. In this way, using arbitration becomes more difficult. However, because this price is not frequently checked, investors still have the opportunity to buy and sell at a profit, as long as it is done immediately, maybe in seconds or minutes.
Example of Simple Arbitration
The arbitration can be briefly explained using the examples given below. Let's assume that a particular CSX Stock is trading at $ 10.20 on the New York Stock Exchange while trading at $ 10.00 on the Nasdaq at the same time. Now, a trader who discovered this loophole exploited it by buying CSX stock from the Nasdaq for $ 10, and immediately selling it for $ 10.20 on the NYSE, earning him a profit of $ 0.20 per share. This may continue until the stock market adjusts their prices to meet the others, or until the Nasdaq runs out of stock of CSX in its inventory.
Examples of Complex Arbitration
In analyzing complex arbitrage, we will look at triangular arbitrage. Although not the most complicated type of arbitration, arbitration is much more complex than the simple arbitration mentioned above. In triangular arbitrage, a person can choose to convert his / her currency to another currency in the bank. After that, he will proceed with the new currency to the second bank and convert it into another currency. Next, he proceeded to the third bank with the new currency and changed it to the first currency, with a profit. If the same bank is used, the bank will have individual information and will adjust the exchange rates to ensure that the individual returns with what they have brought. Therefore, this person thinks it is best to visit another bank to convert one currency into another. Assuming that the individual starts with $ 5 million.
Using the exchange rates above, you would first convert $ 5 million into euros at 0.894, resulting in 4.47 million euros. Now, you will take that amount into Bank B and convert it to Kuwaiti Dinar at 0.34 dinar for one euro. This will give you 1,519,800 KWD. Next, you will visit Bank C and convert KWD to USD at a price of 3.3 dollars per dinar. This will earn you $ 5,015,340. In this case, an additional $ 15,340 becomes your risk-free arbitration.
- Bank A: USD to EUR = 0.894
- Bank B: EUR to KWD = 0.34
- Bank C: KWD to USD = 3.3