What It Is: Arbitrage is the process of exploiting differences in the price of an asset by simultaneously buying and selling it.

In the process the arbitrageur pockets a risk-free return. Differences in prices usually occur because of imperfect dissemination of information. How It Works/Example: For example, if Company XYZ's stock trades at $5.00 per share on the New York Stock Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 -- pocketing the difference of $0.05 per share. Theoretically, the prices on both exchanges should be the same at all times, but arbitrage opportunities arise when they're not. In theory, arbitrage is a riskless activity because traders are simply buying and selling the same amount of the same asset at the same time. For this reason, arbitrage is often referred to as "riskless profit." Arbitrageurs also try to exploit price differences created by mergers. In some cases, they purchase theshares of companies that are the targets of purchase offers, hoping to pocket the difference between the trading price and the eventual cash payment resulting from the merger. Even though this type of strategy is referred to as "arbitrage," it's a bit of a misnomer because there's always a risk that a merger will not actually happen. Because it's not risk-free, merger arbitrage is not "arbitrage" in its truest sense. Why It Matters: Only large institutional investors and hedge funds are capable of taking advantage of arbitrage opportunities. Because they're able to trade large blocks of shares, they can pocket millions in arbitrage profits even if the spread between two security prices is small (and it usually is just pennies). By contrast, individual investors typically don't have the large sums of money needed to take advantage of arbitrage opportunities, and trading fees would eat up any profits an individual arbitrageur hoped to secure. Institutional investors aren't burdened by these same limitations. Of course, small investors and entrepreneurs take advantage of much smaller arbitrage opportunities every single day. For example, if you've ever purchased a bargain-priced item at a garage sale or fleamarket, and then sold that item for a higher price on eBay, then you've profited from a form of arbitrage. The main creator of arbitrage opportunity used to be a lack of real-time communication about prices in other markets, but modern technology has reduced the number of arbitrage opportunities out there. The relatively few arbitrage opportunities that do exist are elusive and don't last for long -when people realize that a security is cheaper in one market than another, their interest in exploiting the opportunitywill drive up the price of the "cheap" security and drive down the price of the "expensive" security until there is no longer a price difference. In this manner, arbitrage does a good job of ensuring equilibrium in the markets.

Arbitrage
The simultaneous buying and selling of a security at two different prices in two different markets, resulting in profits without risk. Perfectly efficient markets present no arbitrage opportunities. Perfectly efficient markets seldom exist, but, arbitrage opportunities are often precluded because of transactions costs.
Purchasing Power Parity and the Long Run We'll take a look at the purchasing power parity theory (PPP theory) and show what the theory implies. The Dictionary of Economics published by The Economist defines purchasing-power parity theory as follows: Purchasing-power parity theory. A theory which states that the exchange rate between one currencyand another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account. To see why, we'll use an example. Purchasing Power Parity and Baseball Bats First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in Mexico, so consumers are much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to see three things happen: 1. American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw in "A Beginner's Guide to Exchange Rates" this will 2. 3. cause the Mexican Peso to become more valuable relative to the U.S. Dollar. The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down. The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up.

Eventually these three factors should cause the exchange rates and the prices in the two countries to change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8 MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off. Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so. You might think that my example of consumers crossing the border to buy baseball bats is unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or thousands of the bats in Mexico then shipping them to the United States for sale. It is also not unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United States and Mexico is not sustainable because an individual or company will be able to gain an arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other market (This is explained in greater detail in What is Arbitrage? ).

Since the price for any one good should be equal across markets, the price for any combination or basket of goods should be equalized. That's the theory, but it doesn't always work in practice. We'll see why on page 2.