It's not hard to reason this one but you migh...
Arbitrage is an economic or financial term. It is essentially a transaction in which one person (or unit, company etc) takes advantage of the price difference of any particular asset between two or even more markets. These assets are generally financial instruments such as bonds, stocks, derivatives and currencies. People who deal in arbitrage are arbitrageurs.
These people then capitalize on this same imbalance between the markets with the profit becoming equal to the difference. It tends to be risk free as it cannot involve any kind of negative cash flow and can propagate at least one positive cash flow. Considering it raises the possibility of an entirely risk free profit at zero cost it seems to be an ideal transaction form. However, these price differences only usually exist for split seconds and in markets all over the world; arbitrage is therefore a highly specialized trade that requires vast financial knowledge, high risk tolerance, and powerful computer systems.
Suppose an arbitrageur finds that there is a $5 difference between the price of a ton of coal six months hence between the markets in Australia and China. He quickly calculates that the cost of shipping the coal between the two markets is $2/ton, and then buys a massive quantity at the lower price, while simultaneously selling at the higher price. He is thus guaranteed a $3 profit per ton traded, and the inefficiency in the market is removed as the prices adjust to reflect his trade.
Most arbitrage at investment banks around the world is now carried out through specialized trading programs run on high-powered supercomputers, as the speed at which price mismatches can be found and corresponding trades executed is critical.
-Pictures courtesy Thinkstock-
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