The Bull

Tuesday 16

October, 201812:55 PM



DICTIONARY : A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

Arbitrage

What does it mean?

 

Arbitrage is the practice of concurrently purchasing and then selling an asset with the goal of profiting from market imbalances in the asset’s pricing. Because financial instruments can be very similar or even identical but may still have price differences, traders can profit by exploiting the price differences in different forms or markets. The goal of most markets is to be completely efficient, meaning that the asset prices in that market always reflect the true value of the assets. Arbitrage is possible only because markets are susceptible to inefficiency.

 

How arbitrage works

 

Traders make risk-free profits when they can purchase a security in one market and then immediately sell it in another market at a higher price. While arbitrage represents a technical flaw in the system, and indeed is technically an exploitation of that flaw, the practice of arbitrage is actually useful for the system, as it ensures that security prices are more likely to return to fair market value, often with a faster turnaround time.

 

The decline of arbitrage

 

The modern technological advancements implemented in financial markets over the years have resulted in a decrease in arbitrage, as pricing errors are much rarer thanks to these advancements. Most traders now use computerized systems to make trades and monitor market values, so traders usually quickly detect these market differentials and act on them. As a result, the error that provided the opportunity for arbitrage is usually rectified swiftly, sometimes within a matter of seconds. Despite advances in technology, arbitrage continues to be an important tool, although as with most technological advances, it merely manages to solve the problem much more quickly rather than eradicating the issue altogether.

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