Arbitrage occurs when an investor can make a profit from simultaneously buying and selling a commodity in two different markets.
For example, gold may be traded on both New York and Tokyo stock exchanges. If the market price temporarily diverges and gold becomes cheaper on Japanese markets, then an arbitrageur could buy in Tokyo and straight away sell in New York to make a profit.
- Perfect information
- Very fast/instantaneous purchasing and selling
- Low/zero transactional costs in purchasing assets
- Low/zero transaction costs in exchanging currency.
The practice of arbitrage will ensure prices in competitive markets will be very close. If there is perfect information and low transaction costs, you would expect only normal profit from engaging in arbitrage. However, if an investor can take advantage of better information or delays in the dissemination of prices, then they can make more profit.
If markets do not allow for profitable arbitrage because prices are very similar, then we say markets are arbitrage-free or in equilibrium.
Purchasing Power Parity
If a car is much cheaper in the US than in Europe, then European customers will try to buy cars from America. This will cause exchange rates to change and reflect different purchasing power. If European customers buy US cars because they are cheaper, this will cause greater demand for US dollars and cause the Dollar to appreciate against the Euro – reducing the gap in EU and US prices.
However, in practice, many physical goods have significant barriers to trade and cost of transactions. In reality, European customers may continue to buy European cars – even if they are €2,000 more expensive than in the US.
Arbitrage works best for assets that can be instantaneously traded electronically.
Arbitrage pricing theory (APT)
This states that the price of an asset can be predicted by a range of factors and market indicators. In particular, the rate of return for an asset is a linear function of these factors. It implies that if an asset is undervalued, an investor should buy as there is a temporary misalignment in the price. If there is misalignment, arbitrage should cause the price in the imperfect market to return to its ‘fair value.’
It forms part of the efficient market hypothesis and assumes markets are perfectly competitive. It also ignores other factors, such as emotionally driven boom and bust cycles to explain a persistent divergence in the price and market price.
As a result, this form of arbitrage is not risk-free – there is no guarantee that an asset’s value can be predicted by these linear models. Booms and busts in financial markets suggest that commodities and assets can move for reasons beyond the limited expected rate of return.
The theory of Arbitrage pricing theory was developed by Stephen Ross in 1976.