In its most basic form, arbitrage is the practice of buying assets on one market and selling them right away on another in an effort to capitalize on a difference in price. This yields a quick reward with no risk.
For instance, if a security’s price on the NYSE and its matching futures contract on the exchange in Chicago are trading at different prices, a trader could simultaneously sell (short) the more expensive of the two and buy the other, benefitting on the price difference.
For this kind of arbitrage, one of the following three conditions must be broken:
On all markets, the same security must trade at the same price.
Two securities must trade at the same price if their cash flows are identical.
A security that trades today at a price that will be known in the future (through a futures contract) must be discounted by the risk-free rate.
Arbitrage is the simultaneous buying and selling of an asset in two marketplaces with the goal of profiting from the price difference.
During takeover negotiations, risk arbitrage is a type of speculation that allows investors to profit on the discrepancy between the acquirer’s valuation of the target company and the stock’s actual trading price.
Market makers have various advantages over regular investors when it comes to arbitrage, including access to more trading capital and real-time news.
The risk-arbitrage formula developed by Benjamin Graham can be used by retail investors to calculate their ideal risk/reward ratio.