Arbitrage is a term used to describe the purchase of a product which is then immediately sold to make a profit. Arbitrage is popular in the stock market or as a means to make profit from goods being sold at differing prices in varying markets. A person who uses arbitrage is called an arbitrageur.
Arbitrage: A Simple Example
A very simple example of arbitrage would be:
- Target is selling ABC DVD for $10. However, on Amazon.com the last 20 copies of ABC DVD have sold for between $30 and $45. A consumer could go to Target and purchase the copies of the movie, then sell them on Amazon for a profit of $20 to $35 per DVD.
While this is a simple version of arbitrage, it should be noted that in small volume deals such as this, it is unlikely that the consumer would be able to make a long term profit for the following reasons:
- Target could run out of inventory on ABC DVD.
- Target could raise the price on the remaining copies because of the increased demand.
- The supply of ABC DVDs could increase on Amazon resulting in a price drop.
More Complex Examples
- The exchange rate in London is £5 = $1000 while the exchange rate in the U.S. is $1000 = £6. Converting the cash in one country, and then in another country in order to maximize on the exchange rate would be arbitrage.
- Arbitrage exists in sports betting. When bookmakers offer various odds it opens the opportunity for betters to spread their cash out among different bookmakers in order take the best odds on each and cover any possible win or lose circumstance. This tactic often results in a small profit, but can be much more at times.
- Global labor arbitrage is the term that describes what is well known as “offshoring.” This is when manufacturing jobs are moved to countries with lower wages thereby saving the corporation a large amount of money in payroll costs.
- Exchange-traded funds, traded in the stock market, are also a means for an arbitrageur to make a profit. Participants in exchange-traded funds exchange shares in underlying securities as well as in the fund. This is different than the sale of other mutual funds since it does not promote shares being bought or sold with the fund sponsor. Prices are set by demand; and, when a drastic premium of the assets occurs, the underlying securities can be bought, converted and then sold in the open market. Similarly, when a drastic discount exists, the securities will be sold.
- Another example of arbitrage could involve organizations such as the New York Stock Exchange and the Security Futures Exchange OneChicago (OCX), e.g.:
- Supposing a stock on the NYSE is not in line with the stock’s corresponding futures contract on OCX. The more inexpensive stock or contract can be purchased and then sold at a higher price on the other market.
- Hedge funds can also use arbitrage to make a profit. Instead of purchasing and selling the same asset, a hedge fund might purchase and sell different derivatives, assets and securities that have similar characteristics. This practice lets the hedge fund “hedge” any big price differences between the two assets.
- The term arbitrage is also utilized by Google to describe those advertisers whose sites are filled with a lot of advertisements. They are banned from advertising on Google since the advertisers will make more money just from hosting the ads than Google would make from a user clicking only once.
In summary, arbitrage basically means the exchanging of one thing for another to take advantage of price differences in two markets, hence earning a profit.