Arbitrage is a risk-free transaction that is profitable for the investor. It is the simultaneous buying and selling of a commodity in two different markets at two different prices.
The classic example is buying watermelons in Mississippi and selling them in Chicago. Watermelons are plentiful and cheap in Mississippi, and scarce and expensive in Chicago. This classic example misses the simultaneous nature of an arbitrage but captures the fundamental market dynamics that make arbitrage possible.
It is the simultaneous element in a true arbitrage that makes removes risk from the transaction. Both the purchase price and the sale price are known at the time of the transaction. This differential is exploited and realized immediately, eliminating the time value of money component of the calculation. In other words, arbitrage gives an immediate profit rather than a profit over time. This differentiates arbitrage from a risk free rate of return on bonds.
Arbitrage opportunities exist because of inefficient markets, but it is just as accurate to say that arbitrage is a mechanism that keeps markets efficient. One theoretical aspect of an efficient market is that all available information is incorporated into the price of a security on that market. If all markets were efficient, all markets would have the same price. However, price differentials between markets do exist, making arbitrage possible. An investor exploiting an arbitrage can be reasonably characterized as an agent of efficiency, communicating the pricing information between the two markets by driving the price of the security to the same point of equilibrium in both markets.
Arbitrage can exist in any market for any commodity. An individual’s life can be arbitraged in the life insurance market, for example, by the simultaneous purchase of an annuity contract (which converts a lump sum into a stream of payments guaranteed for life), and the purchase of a life insurance policy (which converts a stream of payments, the premiums, into a lump sum at the death of the insured).
In a perfectly efficient market the amount received for the lump sum from the annuity company would equal the annual payment required by the life insurance company for a death benefit equal to the initial lump sum. However, it is sometimes possible for an individual to buy an annuity for a lump sum, use only a portion of the annual proceeds to purchase a life insurance policy to replace the lump sum and pocket a positive cash flow for the remainder of their life.
Other arbitrage opportunities arise from fluctuations in currency exchange rates. The stock of a company on two different exchanges may not accurately reflect changes in the exchange rate for the underlying currencies. Investors exploiting this arbitrage bring the price of the security in both markets back in line with the new exchange rate.