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Arbitrage Investing

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Arbitrage Investing is a way to gain riskless profit. How does it work, and can you make money off arbitrage trading as well?

Arbitrage Trading

Every investor is interested in the opportunity for riskless profit. This is the most attractive way to profit from the market. For example, value investors carefully investigate financial ratios such as a stock’s price to earnings ratio in order to determine stocks that are ‘underpriced’ by the market.

As Billingsley notes, the absence of an arbitrage opportunity is at least as important as its presence. While the presence of an arbitrage opportunity implies that a riskless strategy can be designed to generate a return in excess of the risk-free rate, its absence indicates that an asset’s price is at rest.

Arbitrage Trade Caveat

Nonetheless, due to other factors such as transaction costs, resting prices are not necessarily correct. Also, note that market prices are influenced by human decisions, which can naturally be irrational or highly based on emotions. Thus, there may not be a true opportunity for riskless profit.

Advantages of Arbitrage

There are three practical advantages of understanding arbitrage, as Billingsley suggests:

  • First, the no-arbitrage principle can help in pricing new financial products for which no market prices yet exist.
  • Second, arbitrage can be used to estimate the prices for illiquid assets held in a portfolio for which there are no recent trades.
  • Finally, no-arbitrage prices can be used as benchmark prices against which market prices can be compared in seeking misvalued assets.
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