Arbitrage, in terms of economics, is the taking the opportunity to immediately exchange a good or service in a different for a higher price than initially invested. Put simply, a business person commits arbitrage when they buy cheaply and sell expensively.
The Economics Glossary defines arbitrage opportunity as "the opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price." If a person can buy an asset for $5, turn around and sell it for $20 and make $15 for his or her trouble, that is called arbitrage, and the $15 gained represents an arbitrage profit.
These arbitrage profits can occur in a number of different ways including through buying one good in a market and selling that same good in another, through exchanging currencies at uneven exchange rates, or buying and selling options in the stock market.
Arbitrage of One Good in Two Markets
Suppose Walmart is selling the original collector's edition DVD of "Lord of the Rings" for $40; however, a consumer also knows that on eBay the last 20 copies have sold for between $55 and $100. That consumer could then purchase multiple DVDs at Walmart then turn around and sell them on eBay for a profit of $15 to $60 a DVD.
However, it's unlikely that the person will be able to make a profit in this manner for too long, as one of three things should happen: Walmart could run out of copies, Walmart could raise the price on remaining copies as they've seen an increased demand for the product, or the price on eBay could fall because of a skyrocket in supply on its marketplace.
This kind of arbitrage is actually quite common on eBay as many sellers will go to flea markets and yard sales looking for collectibles that the seller does not know the true value of and has priced much too low; however, there are several opportunity costs associated with this including the time spent sourcing lower-priced goods, the research of competing market prices, and the risk of a good losing its value after initial purchase.
Arbitrage of Two or More Goods in the Same Market
In the second type of arbitrage, an arbitrageur deals in multiple goods in the same market, most commonly through currency exchanges. Take the Bulgarian-to-Algerian exchange rate as an example, which currently goes for .5 or 1/2.
The "Beginner's Guide to Exchange Rates" illustrates the point of arbitrage by assuming instead that the rate is .6, wherein "an investor could take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 Bulgarian leva and exchange them back for Algerian dinars. At the Bulgarian-to-Algerian exchange rate, she'd give up 10 leva and get back 6 dinars. Now she has one more Algerian dinar than she did before."
The result of this type of exchange is a detriment to the local economy where the exchange is taking place because that teller is giving back a disproportionate amount of dinars to the number of levas exchanged in the system.
Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian dinars-to-Bulgarian leva exchange rate is 2 and the Bulgarian leva-to-Chilean peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply the two exchange rates together, which is a property of exchange rates known as transitivity.
Arbitrage on Financial Markets
There are all kinds of arbitrage opportunities in financial markets, but most of these opportunities come from the fact that there are many ways to trade essentially the same asset, and many different assets are influenced by the same factors, but primarily through options, convertible bonds, and stock indices.
A call option is a right (but not obligation) to buy a stock at a price given the option, wherein an arbitrageur could buy and sell in a process commonly known as "relative value arbitrage." If someone were to buy a stock option for Company X, then turn around and sell it at a higher value because of that option, this would be considered arbitrage.
Instead of using options, one can also perform a similar type of arbitrage by using convertible bonds. A convertible bond is a bond issued by a corporation which can be converted into the stock of the bond issuer, and arbitrage on this level is known as convertible arbitrage.
For arbitrage in the stock market itself, there is a class of assets known as Index Funds which are basically stocks which are designed to emulate the performance of a stock market index. An example of such an index is a Diamond (AMEX: DIA) which mimics the performance of the Dow Jones Industrial Average. Occasionally the price of the diamond will not be the same as the 30 stocks which make up the Dow Jones Industrial Average. If this is the case, then an arbitrageur can make a profit by buying those 30 stocks in the right ratio and selling the diamonds (or vice-versa). This kind of arbitrage is quite complex, as it requires you to buy a lot of different assets. This type of opportunity generally does not last very long as there are millions of investors who are looking to beat the market any way they can.
Avoiding Arbitrage Is Essential to Market Stability
The possibilities for arbitrage are everywhere, from financial wizards selling complicated stock derivatives to video game collectors selling cartridges on eBay they found at yard sales.
However, arbitrage opportunities are often hard to come by, due to transaction costs, the costs involved with finding an arbitrage opportunity, and the number of people who are also looking for that opportunity. Arbitrage profits are generally short-lived, as the buying and selling of assets will change the price of those assets in such a way as to eliminate that arbitrage opportunity.