Arbitrage Definition, Example and Importance
Arbitrage Definition – “It refers to the profit earned by buying the security from exchange where the price is low and selling at higher prices in the other exchange.”
It is a profit making activity which takes the advantage of lower prices in one exchange and then sell at higher rate in the exchange with high prices. However, this profit making opportunity exist only for few minutes till the prices in both the exchanges does not become equal. Here the exchange means the stock exchange of the country like NSE and BSE.
The main reason behind the arising of this opportunity is the lack of communication between the two markets. However, now the technology has become so advance that, such opportunity hardly arises.
Well the mechanism is very simple. A stock is traded in various exchanges. So, there arise some occasions when the price differ a bit in the exchanges. This result in creating the opportunity of arbitrage for the traders. They buy from low price exchange and sell in high price exchange. In India, in currency market the arbitrage opportunity is quite common but now it also happens in commodity, futures and stock.
In order to understand the arbitrage definition clearly, look at the example given below –
Let’s assume the share of TATA motors is trading at 447 rupees in NSE. Now the same stock is available at 455 in BSE. You are A trader, you saw this opportunity and bought 100 shares from NSE and sold it in BSE. So the arbitrage that you earn is –
Arbitrage = 455 × 100 – 447 × 100
= 45500 – 44700
Importance of Arbitrage
Well, the retail investors hardly go for arbitrage as they have limited amount of funds. Plus they also have to give the trading fees to the arbitrageurs. So they discourage such type of trading.
Players who make profit out of this opportunity are the hedge fund managers or large financial companies. Although the difference is very minimum. Still firms are able to make millions as they invest huge sum.