Arbitrage in the Real World
January 22, 2018
When getting into the investment game, you might hear about arbitrage. It’s a fancy word that basically means making a profit without any risk. Well you may ask yourself how this can happen, and of course how you can get in on it. Sadly it doesn’t occur very often in the market, but it can and does occur. To better understand why we will look at areal world example and then translate that into the world of finance.
If you were to go to a flea market and see a Mickey Mantle rookie card selling for $5, you may quickly realize that its worth more elsewhere. The simple idea would be to buy it and go sell it later. This isn’t really arbitrage because you would then have risked your $5 in hopes of earning more. In this situation you would need to find a buyer on the other side of the flea market who wants to purchase the card from you for $50, take their money and use it to buy the card and bring it back to them. This way your money was never at risk, and you still made an incredible profit. It may seem a little dishonest, but in all reality the customer you sold to wanted to pay $50 for the card, and the person you bought it from wanted $5 for it, so everyone got what they wanted and you were simply able to broker a deal with some nice gain for yourself.
These situations may be few and far between, but in the world of finance they can be found. In this age of technological advancement it becomes harder and harder since more information is available to more and more people. Arbitrage is based on that difference in available information, you are essentially earning by knowing more than the other two parties involved.
One place where this still occurs in finance is in monetary exchange rates. Sometimes when these exchange rates change they don’t all change at the same time allowing for some arbitrage until they catch up to each other. For example if the exchange rates are all even between the US dollar the Euro and The Canadian Dollar, lets say 1=1=1 and then the rate changes between the US Dollar and The Euro, lets say $1.50 to One Euro the Canadian exchange rates between the two, before it catches up to the new rate would create an ideal method for arbitrage since it would still be 1=1=1. You could essentially, by exchanging dollars into Canadian dollars then into Euros still get the old rate of return and get profit when you convert those Euros into dollars using the new rate of 1 to 1.5. No risk and great return, the perfect example of arbitrage.