Meaning of Arbitrage

ARBITRAGE

The arbitrage or an arbitrage business describes on the stock exchange the exploitation of price differences for the same asset at different trading venues. Equities and bonds as classic securities serve as underlyings in arbitrage transactions, futures in the area of ​​derivatives are also ideally suited for this trading method due to their high volatility.

  • The arbitrage or an arbitrage business describes on the stock exchange the exploitation of price differences for the same asset at different trading venues.
  • Not all possible forms of trade are approved by the economy. For example, highly speculative derivatives are seen as a threat to the financial markets.

How an arbitrage business works

A very simple example, which can also work on the German stock market, would be buying and selling a share. The X share is listed in Frankfurt at 50 euros and in Stuttgart at 50.50 euros. The trader buys the shares for 50 euros in Frankfurt and immediately sells them on the Stuttgart Stock Exchange with a profit of 50 cents. Arbitrage trading becomes much more serious, but also riskier, if it is carried out on two exchanges with different currencies. The obvious price gain is offset by the risk of a price decline on the currency side. A share is bought in New York in US dollars and could be resold in Tokyo at a profit. However, if the relationship between the US dollar and the yen deteriorates at the time of the sale, this fact also minimizes the profit.

Types of arbitrage business

Arbitrage does not only take place on the stock exchanges. Economics distinguishes between four types of arbitrage according to digopaul:

Geographic arbitrage

Geographic arbitrage is based on reduced transport costs and faster communication channels. Economic goods can be acquired quickly and efficiently at a corresponding price. The arbitrageur has the advantage that he can find out the price of a commodity faster than his competitors.

Cultural arbitrage

Cultural arbitrage does not relate to cultural goods, but to culturally determined pricing. If a food is considered a staple food in one country, it can be obtained more cheaply there than elsewhere. The arbitrageur adopts this fact and buys the goods where they are subsidized and sells them elsewhere, where a higher, because unsubsidized, price is paid.

Mathematical arbitrage

Mathematical or statistical arbitrage considers two assets in terms of mutual correlation. If the price of one good changes to the other and the correlation between the two goods is violated, there is the possibility of trading for profit, since it is assumed that the prices will correlate again at a later point in time.

The economic arbitrage

Although all arbitrage businesses have their origins in economics, there are also issues that cannot be assigned to geographical, cultural or mathematical arbitrage. These transactions, which cannot be clearly assigned, are summarized under the generic term economic arbitrage.

Economic consideration

Not all possible forms of trade are approved by the economy. For example, highly speculative derivatives are seen as a threat to the financial markets. Arbitrage businesses, on the other hand, enjoy a positive reputation because, in the eyes of economists, they ensure transparent markets and make the market efficient. Under ideal market conditions, arbitrage deals are completely risk-free. The risk, however, is the moment the arbitrage brings about its positive approach, the transparency of the markets. The buyer will no longer purchase the goods via the arbitrageur, but will also buy them in the cheaper market.

ARBITRAGE