The Concept of Economic Arbitrage Defined

In economics, investment and sports, arbitrage  is the practice of taking advantage of a price difference between several markets: striking a mix of matching deals that take advantage upon the imbalances, the profit being the difference between the market prices.

When used by academics, an arbitrage is actually a transaction that involves no damaging cash flow at any probabilistic or temporal state plus a positive cash flow in at least one state; basically, it’s the possibility of a risk-free profit at zero cost.

In principle and within academic use, an arbitrage is risk-free; in common use, for example statistical arbitrage, it may well mean anticipated profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (including change of prices decreasing income), some major (which include devaluation of your currency or derivative).

In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it’s also used to reference differences between similar assets (relative value or convergence trades), as in merger arbitrage.

Individuals that practice arbitrage are called arbitrageurs possibly a bank or brokerage firm. The word is mainly given to trading in financial instruments, like bonds, shares, derivatives, commodities and currencies.

Sports arbitrage has additionally recently become possible due to the use of web-based bookmakers giving widely diverging odds on sports establishing situations where you’ll be able to place bets that cannot lose.

Despite the fact that this involves bookmakers this isn’t gambling as there isn’t any risk to the initial stake which can’t be lost. This is whats called ‘Arbitrage Betting‘ or ‘Matched Betting‘

Arbitrage isn’t simply the act of buying a physical product within a market and selling it in another for a larger price at some later time. The transactions must happen simultaneously in order to avoid exposure to market risk, or maybe the risk that prices may change in one market before both deals are completed.

In practical terms, this is generally only possible with securities and financial products which might be traded electronically, and even then, when each leg of the trade is accomplished the prices in the market may have moved.

Missing one of the legs from the trade (and subsequently needing to trade it soon after at a worse price) is called ‘execution risk’ or more specifically ‘leg risk’.

“True” arbitrage requires that there be no market risk involved.