Arbitrage basics | Finance & Capital Markets | Khan Academy

Summary

Arbitrage is a simple but powerful concept where you exploit price differences for the same product in different markets to make risk-free profit. Using the example of apples, if one market sells apples for $1 and another for $1.50, you can buy apples from the cheaper market and sell them in the more expensive one. This process generates immediate profit, and as it continues, it increases supply in the cheaper market and demand in the more expensive one, causing the prices to converge. The opportunity for arbitrage exists as long as there’s a price discrepancy between markets.

Takeaways

• 😀 Arbitrage refers to the process of exploiting price differences for identical items in different markets to make a risk-free profit.
• 😀 The example given involves buying apples in a cheaper market and selling them in a more expensive one to make a profit.
• 😀 In the example, apples are bought for $1 each and sold for $1.50 each, resulting in a profit of $5 for 10 apples.
• 😀 Arbitrage profits arise because of the price gap between two identical products in different locations.
• 😀 As you continue the arbitrage process, you can keep repeating the cycle of buying and selling, making a profit each time.
• 😀 Over time, arbitrage leads to price adjustments: increased supply in the cheaper market and increased demand in the more expensive market.
• 😀 The increase in supply in the cheaper market causes the price to drop, while the increase in demand in the expensive market pushes the price up.
• 😀 Eventually, if enough arbitrage occurs, prices in both markets will converge, eliminating the opportunity for profit.
• 😀 The concept of arbitrage is risk-free as long as there is a price discrepancy, and it relies on market forces to adjust prices over time.
• 😀 The more arbitrage occurs, the smaller the price difference becomes, eventually making the opportunity disappear once the markets balance.
• 😀 Arbitrage helps illustrate basic economic principles like supply and demand, showing how market forces work to balance prices.

Q & A

What is arbitrage?

Arbitrage is the practice of taking advantage of price differences for essentially the same item in different markets, allowing one to make a risk-free profit.

Can you give an example of arbitrage in everyday life?

An example of arbitrage would be buying apples in a market where they cost $1 each and selling them in another market where the same apples sell for $1.50 each, making a profit of $0.50 per apple.

What happens when a person keeps engaging in arbitrage?

When arbitrage is performed repeatedly, it increases the supply of the product in the cheaper market and raises the demand in the more expensive market. This eventually causes the prices to adjust and come closer to each other.

How does arbitrage affect market prices over time?

Over time, arbitrage leads to market adjustments—prices in the cheaper market rise due to increased demand, while prices in the more expensive market fall due to increased supply. Eventually, the price difference reduces, and arbitrage opportunities disappear.

Why is arbitrage considered risk-free?

Arbitrage is considered risk-free because it involves taking advantage of existing price differences without any inherent financial risk, assuming there are no unexpected costs or changes in price before the transaction is completed.

What role does supply and demand play in the arbitrage process?

Supply and demand play a critical role in arbitrage because as the arbitrageur buys goods from the lower-priced market and sells them in the higher-priced market, the supply increases in the cheaper market and demand rises in the more expensive one, pushing prices toward equilibrium.

How does arbitrage contribute to market efficiency?

Arbitrage helps improve market efficiency by correcting price discrepancies across different markets, ensuring that identical goods are priced similarly, which leads to better resource allocation and fairer pricing.

Can arbitrage opportunities last forever?

No, arbitrage opportunities do not last forever. As the process continues, the markets adjust their prices, reducing the price differences and eliminating the profit opportunities. Once the prices align, arbitrage no longer works.

What would happen if many people started doing arbitrage in the same market?

If many people engage in arbitrage in the same market, the price differences will close even more quickly as the supply in the cheaper market increases and the demand in the expensive market rises, leading to the eventual disappearance of profitable arbitrage opportunities.

Why might an arbitrage opportunity not be entirely risk-free in practice?

In practice, arbitrage may not be entirely risk-free due to factors like transaction fees, shipping costs, market fluctuations, or unexpected price changes, all of which could affect the profitability of the arbitrage opportunity.