Arbitrage is buying a
security in one market and at the same time selling it in another market at a
higher price, making a profit from the differences in prices.
Within the stock market
traders exploit the arbitrage opportunities by buying low in one market, and
sell high in another market. In the case of the stock market a trader buys a
stock in the foreign exchange where the price fluctuations have not yet settled
due to say the exchange rates.
The price of a stock or
currency is undervalued in one market compared to the price on the local
exchange, and a profit is gained from this difference. If all markets were
perfectly efficient there would be no arbitrage and markets would be perfect.
In economics the efficient market hypothesis is a theory that states that an
asset’s price fully reflects all available information, or in the case of the
stock market, a stock’s price fully reflects all prior public information.
Because a stock’s price reflects all available public information, it is
impossible to beat the market. That is the notion of the efficient market hypothesis,
thus there would be no arbitrage.
Transaction costs can
turn an arbitrage into a zero benefit for an arbitrageur. If trading costs are
more than the total arbitrage return there would be zero arbitrage. Below is a
schematic diagram of the efficient market hypothesis.
Triangle arbitrage is
exploiting an arbitrage opportunity between currencies from a price discrepancy
in the foreign exchange market. In the triangular arbitrage, as depicted in the graph below, it involves three
trades between three currencies, as the graph depicts below. One exchanges
(converts) the initial currency for the second, then for the third, and finally
for the initial. Notice below, that the first step is exchanging US dollars for Canadian dollars, with the exchange rates giving. The second step, is converting Canadian dollars for Swiss Franks, and finally selling Swiss franks and buying back US dollars, thus making a profit of $1000.
