Arbitrage; in simple words is a strategy to make riskless profit by buying an asset in one market and selling it in another market at higher price. Arbitrage is a kind of trade that involves no or very little risk; where traders try to exploit the price difference for a financial security across different markets.
Why there is an opportunity for Arbitrage: One of the primary reasons for the existence of opportunity for arbitrage is market in-efficiency. As per efficient market theory; in-efficient markets do not reflect the latest market price of an asset or there is delay (lag of even a second can be exploited by high frequency trading firm) in latest price update of an asset.
Breaking down Arbitrage: Arbitrage is a trading strategy of simultaneously buying an asset at lower price in one market and selling in another market at higher price thus giving an opportunity to trader to make a riskless profit.
Though with advancement in technology; it is almost impossible with human intervention to make risk free profit using any kind of arbitrage opportunity but still high frequency trading (HFT) firms with the help of trading algorithms running on computers try to exploit such opportunities; even if such opportunities exists for few milli seconds.
Arbitrage example: Let us try to understand arbitrage with the help of a simple example. Suppose, the stock of ICICI is trading at Rs. 400 at National Stock Exchange (NSE); while at the same moment it is trading at Rs. 400.05 at Bombay Stock Exchange (BSE). A trader having an access to smart trading algorithm will exploit this price difference by short selling stock at BSE while buying the same stock at NSE and making a risk free profit of .05 per share and if does this for 1 lakh shares he can make risk free profit of Rs. 5000.
In the following articles we would learn more about arbitrage and try to understand if Arbitrage trading is always risk free. We would also try to compare Arbitrage Pricing theory with Capital asset pricing model.