The use of Arbitrage in financial markets: Are they bets you can’t lose?
In business economics, finance and sports, arbitrage is the method of taking advantage of a price difference between two or more markets: striking a variety of matching deals which capitalize upon the asymmetry, the profit being the gap amongst the market prices.
When utilized by academics, an arbitrage is often a transaction that needs no damaging cashflow at any probabilistic or temporal state plus a positive income in one or more state; basically, it is the probability of a risk-free gain at zero cost. In effect free money from deals where no risk existed.
In banking markets this is known as ‘Arbitrage’. In sports markets it is called Matched Betting.
In principle and within academic use, an arbitrage is risk-free; in common use, for example statistical arbitrage, it might refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (along the lines of change of prices decreasing income), some major (for example devaluation of a 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 might be used to focus on differences between similar assets (relative value or convergence trades), for example merger arbitrage.
People who participate in arbitrage are called arbitrageurs possibly a bank or brokerage firm. The word is mainly related to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.
Specific sport arbitrage has also recently become possible because of the use of world-wide-web bookmakers supplying widely diverging odds on sporting events creating situations where you’re able to place bets that cannot lose.
Despite the fact that this involves bookmakers this isn’t gambling as there is no risk on the initial stake which can’t be lost.
Arbitrage is not simply the act of purchasing a physical product in one market and selling it in another for a larger price at some later time. The transactions must take place simultaneously in order to avoid exposure to market risk, or the risk that prices may change on a single market before both deals are complete.
In realistic terms, this can be generally only possible with securities and financial products which may be traded electronically, and even then, when each leg of this trade is performed the values sold in the market may have moved.
Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is known as ‘execution risk’ or more specifically ‘leg risk’.
“True” arbitrage mandates that there be no market risk concerned.
