What is Arbitrage
What is Arbitrage? Understanding what arbitrage is is essential to sound risk management and successful investment. Arbitrage Strategies, Arbitrage Definition, Arbitrage Pricing Theory.
Arbitrage Definition
Arbitrage is defined as the process of earning riskless profits by taking advantage of different prices for the same good, whether priced individually or in combination.
What is Arbitrage Trading
Arbitrage Trading is an approach to identifying and profiting from assets that are misvalued. It involves buying assets in one market and selling them in another in order to profit from unjustifiable price differences. Traditionally, the ideal form of arbitrage is both riskless and self-financing; the investor uses money that does not even belong to himself.
Otherwise, if a positive outlay is necessary in order to take advantage of the arbitrage opportunity, there is a risk that the initial investment could be lost.
As an economic mechanism, arbitrage helps to structure asset prices. This ensures that investors earn expected returns that are proportional to the risks they bear.
Arbitrage Pricing Theory (APT)
Law of One Price
The Law of One Price is a guiding rule in investments. Central to the Arbitrage Pricing Theory, the Law of One Price states that the same investment must have the same price no matter how the investment is created. For example, there can be identical investments using different underlying assets and securities. These investments must have the same expected cash flow and payoffs. Otherwise, the threat of arbitrage will force the Law of One Price to come into place, as arbitrageurs take advantage of the differential and therefore eliminate the mis-valuation.
The Law of One Price also applies to assets that are combined together. Buying combinations of assets should not result in a higher price than buying the assets individually. Otherwise, arbitrage opportunities will arise and force the prices down.
How do you compare different financial securities? By the two basic outcomes: expected returns and risk. Through the discipline of the profit motive, the Law of One Price will force assets with the same expected returns and risks but different prices to have identical prices.
Law of One Expected Return
What is arbitrage? Similar to the Law of One Price, the Law of One Expected Return states that identical investments should have the same expected return. This is subtly different from the previous law, which focuses on price across markets.
