What is Arbitrage?

L. S. Wynn
L. S. Wynn
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Arbitrage is the activity of exploiting imbalances between two or more markets. Foreign money exchangers operate their entire businesses on this principle. They find tourists who need the convenience of a quick cash exchange. Tourists exchange cash for less than the market rate and then the money exchanger converts those foreign funds into the local currency at a higher rate. The difference between the two rates is the spread or profit.

There are plenty of other instances where one can engage in the practice arbitrage. In some cases, one market does not know about or have access to the other market. Alternatively, arbitrageurs can take advantage of varying liquidities between markets.

The term 'arbitrage' is usually reserved for money and other investments as opposed to imbalances in the price of goods. The presence of arbitrageurs typically causes the prices in different markets to converge: the prices in the more expensive market will tend to decline and the opposite will ensue for the cheaper market. The the efficiency of the market refers to the speed at which the disparate prices converge.

Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk is the potential for rapid fluctuations in market prices. For example, the spread between two markets can fluctuate during the time required for the transactions themselves. In cases where prices fluctuate rapidly, would-be arbitrageurs can actually lose money.

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