Definition Arbitrage: Arbitrage is the situation where people take advantage of different buying and selling prices in different markets, to make small amounts of profit.
In some financial markets there is a very small margin between the buying price and the selling price. Furthermore this particular good maybe traded around the world. The prices may temporarily diverge giving the opportunity for an arbitrageur to make profit by buying in one market and selling in different markets.
To be successful an arbitrageur will need to act quickly. In theory the practice of arbitrage should bring global prices together.
Example of Arbitrage Pricing Theory
Suppose the market for $ in the UK is: £1 = $2.01
and in Japan £1 = $2.01
If there was a sudden increase in demand for sterling in the UK. The £ would rise in the UK £1=$2.10. If markets are not perfectly competitive there may be a lag effect so that £ are cheaper in Japan (stay at £1 = $2.01). Therefore you could buy £in Japan and then immediately sell them in UK markets. This would give you a small but guaranteed profit. As arbitrageurs do this it will help bring the two markets into line. The speed with which markets are brought into line depends upon how many people seek to do this.
This example of arbitrage is quite rate because it is so obvious. Arbitrage is more common amongst more obscure financial instruments such as forward exchange rates and commodity prices
Interest Rate arbitrage.
This occurs when investors take advantage of different interest rates around the world. For example, Japanese interest rates are very low. Therefore, this encourages people to buy Yen and borrow from Japanese banks. This low rate of borrowing can then be used to make profit by depositing the money in countries with high interest rates.