In business economics, finance and sports, arbitrage is the method of taking advantage of a price difference between 2 or more markets: striking the variety of matching deals that capitalize upon the discrepancy, the profit being the gap amongst the market prices.
When used by academics, an arbitrage can be described as transaction that involves no damaging cashflow at any probabilistic or temporal state including a positive cash flow in one or more state; simply, it’s the chance of a risk-free profit at zero cost.
In principle as well as in academic use, an arbitrage is risk-free; in common use, for example statistical arbitrage, it may well make reference to anticipated profit, though losses may arise, and in practice, there are always risks in arbitrage, some minor (for instance fluctuation of prices decreasing income), some major (for instance devaluation of your currency or derivative).
In academic use, an arbitrage involves taking advantage of variations in cost of a single asset or identical cash-flows; in common use, it is usually used to make reference to differences between equivalent assets (relative value or convergence trades), such as merger arbitrage.
People who engage in arbitrage are called arbitrageurs perhaps a bank or brokerage firm. The word is principally applied to trading in financial instruments, like bonds, stocks and shares, derivatives, products and currencies.
Sports arbitrage has also recently become feasible mainly because of the accessibility to world wide web bookmakers providing widely diverging odds on sports setting up situations where it is possible to place bets that cannot lose.
Despite the fact that this involves bookmakers it’s not gambling as there isn’t any risk on the initial stake which cannot be lost. This is known as ‘Arbitrage Betting‘ or ‘Matched Betting‘
Arbitrage isn’t simply the act of buying a physical product in a single market and selling it in another for a better price at some later time. The deals must take place simultaneously in order to avoid exposure to market risk, or perhaps the risk that prices may change on one market before both dealings are completed.
In functional terms, this is generally only possible with securities and financial products that may be traded electronically, and even then, when each leg of this trade is completed the prices available in the market could possibly have moved.
Missing one of the legs of the trade (and subsequently being forced to trade it soon after at a worse price) is known as ‘execution risk’ or more specifically ‘leg risk’.
“True” arbitrage mandates that there be no market risk included.