Arbitrage
The simultaneous purchase and sale of equivalent assets in different markets to profit from a price discrepancy — in theory risk-free, in practice subject to execution risk, funding constraints, and the possibility that prices diverge further before converging.
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What Is Arbitrage?
Pure arbitrage is the simultaneous purchase and sale of the same asset — or equivalent assets — in different markets at different prices, locking in a risk-free profit from the price discrepancy. In perfectly efficient markets, arbitrage opportunities are instantly eliminated by the traders who exploit them.
Simple example: Gold trades at $3,400 on London markets and $3,402 on New York markets simultaneously. A trader buys in London and sells in New York, pocketing $2 per ounce risk-free (minus transaction costs).
Why True Arbitrage Is Rare
In modern markets, electronic trading and sophisticated algorithms eliminate pure price discrepancies within milliseconds. What remains are:
- Statistical or probabilistic mispricings (not truly risk-free)
- Structural arbitrages that require capital, time, and tolerance for temporary losses
- Near-arbitrages with basis risk — the positions aren't perfectly equivalent
Types of Arbitrage in Practice
Convertible bond arbitrage: Buy a convertible bond (which can be converted to equity) and short-sell the underlying stock. Profit from mispricing of the conversion option.
Merger arbitrage (risk arb): When a takeover is announced at $50/share and the stock trades at $48, buy the stock and earn $2 when the deal closes. Risk: the deal fails.
ETF arbitrage: If an ETF trades at a premium to its net asset value (NAV), authorised participants buy the underlying basket and redeem it for ETF shares, capturing the premium. This mechanism keeps ETF prices aligned with NAV.
CDS-bond basis: If a corporate bond trades at a higher yield than the equivalent CDS-implied spread, buy the bond and buy CDS protection — theoretically zero risk, but requires funding and counterparty management.
Statistical arbitrage (stat arb): Trade pairs of historically correlated assets when the relationship temporarily diverges, betting on mean reversion.
The Limits of Arbitrage
Shleifer and Vishny showed in their famous 1997 paper that arbitrage has limits — it can fail when:
- Capital constraints: Positions require funding that may be withdrawn at exactly the wrong moment
- Horizon risk: Prices can diverge further before converging; short-term losses trigger margin calls
- Noise trader risk: Markets can stay "wrong" longer than you can stay solvent
LTCM's 1998 collapse was the archetypal limits-of-arbitrage failure: correct convergence trades that were correct ultimately, but required more capital and time than the fund had.
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