The Role of Arbitrage

In well-functioning markets with low transaction costs and a free flow of information, the same asset cannot sell for more than one price. If the same asset trade at a higher price in one place and a lower price in another, then market participants would sell the higher-priced asset and buy the lower-priced asset. In doing so, they would earn a riskless profit, and the combined action would force the two prices to converge. This simultaneous transacting to take advantage of a price mismatch is known as arbitrage.

The Law of One Price

The fact that the arbitrage process forces prices to converge is often referred to as the law of one price. For the strategy to be feasible, the ability to go both long and short of an asset is important.

Arbitrage Strategies

The simplest opportunity for arbitrage might be if a particular stock trades on two different exchanges for two different prices. The lower-priced stock would be bought and immediately sold at the higher price, netting a profit with no capital commitment. However, it is important to note that arbitrage does not give us information on which price (higher or lower) reflects the fundamental value of a stock. Thus, arbitrage is not an absolute valuation methodology, but it provides a relative valuation – the correct price of one asset relative to another.

An arbitrage strategy could be applied to two stocks where the relative valuation between the two is mispriced. Again, we would short sell the overpriced stock and buy the underpriced stock. The proceeds from the short sale would cover the cost of the long position enabling the position to be entered without capital commitment. As the prices converged at some time in the future, the short and long positions are unwound to generate a profit.

Arbitrage opportunities do exist temporarily but tend to be quickly exploited to bringing relative prices back into line with each other. Some apparent arbitrage opportunities may be too small to be worth exploiting, given transaction costs.

Arbitrage Impact on Market Pricing

The law of one price and the lack of arbitrage opportunities are only upheld when market participants actively seek out such opportunities. For arbitrage opportunities to be eliminated, traders must closely follow and compare prices. Although abnormal returns can be earned in various ways, arbitrage profits are definitely examples of abnormal returns and violate the principle of market efficiency. We typically assume that arbitrage opportunities cannot exist for any great length of time and that one investor cannot consistently capture them. Thus, prices must conform to a model that assumes no arbitrage.

Question

Which statement best describes arbitrage?

A. Arbitrage is the opportunity to make consistent abnormal returns due to market inefficiency

B. Arbitrage, also known as the law of one price, means the ability to profit from price mismatches lasting for a very short time

C. Arbitrage allows market participants to determine the true, fundamental price of an asset

Solution

The correct answer is B.

Arbitrage opportunities do allow investors to make risk-free returns without capital commitment but such opportunities do not persist for any length of time and cannot be consistently captured.