Definition: Arbitrage is the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on the exchange-rate differentials in various markets.
The arbitrage opportunities exist due to the inefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, the price differential is captured as a trade’s net payoff. This payoff should be large enough to cover the expenses incurred in executing the trade.
For example: Suppose the stock of company A is trading at Rs 2000 on BSE while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of Rs 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity.
The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets.
The arbitrage opportunity can be availed only where the foreign exchange is free from controls, and if any, controls should be of limited significance. If the sale and purchase of foreign exchange are under severe control and regulation, then the arbitrage is not possible. Practically, the arbitrage opportunity exists for a very brief period since in the mature markets the most of the trading has been taken by the algorithm-based trading (a trading system that relies heavily on mathematical formulas and computer programs to determine the trading strategies). These algorithm-based trading are quick to spot and is quite easy for a trader to keep track.