Arbitrage opportunity

Definition

An arbitrage opportunity is a situation in which an investor can exploit price differences in different markets or forms of an asset to secure a risk-free profit. This usually involves buying an asset at a lower price in one market and simultaneously selling it at a higher price in another, benefiting from the discrepancies. Understanding this concept is crucial in finance as it relates to the efficient market hypothesis and option pricing models, where prices are expected to reflect all available information.

5 Must Know Facts For Your Next Test

1. Arbitrage opportunities exist only in markets that are not fully efficient, allowing traders to benefit from price discrepancies.
2. These opportunities are typically short-lived as they attract traders who quickly act to eliminate the price differences.
3. In the context of options pricing, arbitrage can help verify whether option prices adhere to models like the Black-Scholes model.
4. Investors engaged in arbitrage help bring prices back into equilibrium, contributing to market efficiency.
5. Arbitrage requires no risk, but it may involve transaction costs and requires quick execution to capitalize on the opportunity.

Review Questions

• How do arbitrage opportunities relate to the concept of market efficiency?
  • Arbitrage opportunities directly challenge the concept of market efficiency. When prices of assets are not aligned across different markets, it indicates that the market has not incorporated all available information. Efficient markets should theoretically eliminate arbitrage opportunities because traders would quickly buy low and sell high until prices stabilize. Therefore, identifying arbitrage suggests there is inefficiency within the market that can be exploited.
• Discuss how Put-Call Parity is essential for understanding arbitrage opportunities in options trading.
  • Put-Call Parity establishes a crucial relationship between call and put options with identical strike prices and expiration dates. If this relationship is violated, it creates an arbitrage opportunity. Traders can exploit this discrepancy by simultaneously buying and selling these options to lock in a risk-free profit. Thus, understanding Put-Call Parity is vital for traders looking for potential arbitrage situations within options markets.
• Evaluate how transaction costs impact the viability of exploiting arbitrage opportunities in financial markets.
  • Transaction costs can significantly affect the feasibility of exploiting arbitrage opportunities. While these opportunities are theoretically risk-free, the reality is that fees associated with buying and selling assets can erode potential profits. If the cost of executing trades is higher than the profit gained from arbitraging price differences, then the opportunity becomes unviable. Therefore, successful arbitrageurs must factor in these costs when determining whether an opportunity is worth pursuing.

Related terms

Efficient Market Hypothesis: A theory that asserts that financial markets are 'informationally efficient,' meaning that prices of securities reflect all known information at any given time.

Put-Call Parity: A fundamental principle in options pricing that defines a relationship between the price of European call options and European put options with the same strike price and expiration date.

Market Inefficiency: A situation where asset prices do not reflect all available information, leading to opportunities for traders to profit from mispriced securities.