- What is arbitrage in simple language?
- Why and how does arbitrage arise?
- What are the arbitrage opportunities in the economy?
The root of the word arbitrage
Arbitrage is a word of French origin. For centuries, this word was used to mean “judgment”. But if your question is what these meanings have to do with the economy, we should look for the answer in the 18th century. In 1704, a person named “Mathieu de la Porte” wrote an economic treatise and for the first time used the word “arbitrage” in a sense other than “arbitration”. He wrote: “Arbitrage is an opportunity to profit from the simultaneous price difference of an asset between two or more markets.” Thus, the word arbitrage was born in the financial markets.
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What does this definition of arbitrage mean?
Suppose a product is bought and sold in Tehran at the price of one thousand tomans. The same product is traded in Karaj for 1,200 tomans. In this case, you might not mind buying the goods in Tehran and selling them in Karaj. By doing this, you have used an arbitrage opportunity.
Isn’t this our own export?! Keep in mind that arbitrage is only possible when the asset sale platform is fully in place and we do not need to introduce or market the product. So things like exporting goods are not considered arbitrage. One of the main features of arbitrage is that it is risk free. While concepts like export are not without risk.
Thus, the simple definition of arbitrage is to make a profit from the price difference in two or more markets. This difference can be “time difference” or “location difference” between two markets.
Remember the example of Tehran and Karaj; There we were facing an arbitrage due to the difference in location. But you may buy a product that you can be sure will be 20% more expensive in a month. There is a time arbitrage opportunity here. We can see a concrete example of it in the price difference in the cash market compared to futures.
In front of the arbitrage opportunity, there is the arbitrage balance, which you must guess what it is; A situation where the prices in different markets are equal or their differences are so small that they do not create an arbitrage opportunity. In this case, we say that the arbitrage equilibrium is established.
Arbitrage opportunities in different financial markets
Arbitrage in global markets
In 2018, the price of copper on the London Metal Exchange was 2% different from the Chicago Mercantile Exchange. This two percent meant $132 per ton. This is an example of one of the biggest arbitrage opportunities in global markets. There are many examples of this price difference in different markets. Although we may think that, for example, the price of every commodity is the same all over the world, these differences can be great arbitrage opportunities for the participants of these markets.
Arbitrage in forex
The same thing that we mentioned in the above example also happens in the forex market. The existence of different brokers and the size of the forex market create many arbitrage opportunities. However, the presence of many traders and trading opportunities makes these forex arbitrage opportunities to be covered very quickly. Due to this issue, such work can only be done with the help of robots and algorithmic transactions in this market.
Arbitrage in digital currencies
Let’s assume that you fell in love with IOTA Cryptocurrency after reading the IOTA Cryptocurrency View Report and decided to take an arbitrage opportunity on it. As you can see in the picture below, on the day of writing this article, the price of the IOTA/Teter currency pair in different exchanges is 14 cents, that is, there is a difference of about 11%.
If this 14 cents also covers transaction fees, it could be an arbitrage opportunity in digital currencies. You can search for the digital currency you want on the coinmarketcap.com site, check and compare it in different markets and find out about its arbitrage opportunities.
Types of arbitrage in digital currencies
There are three different ways to benefit from arbitrage both in the digital currency market and in the forex market:
It is the same method as mentioned in the picture. This arbitrage is possible when a digital currency is exchanged in more than one exchange. Then it is possible to buy it from one exchange and sell it in another exchange.
Suppose we buy ethereum with Rial, then sell ethereum and receive euros in return. Now let’s convert Euro to Rial again and all these exchanges will make us earn some profit. In this case, we have made a triangular arbitrage.
Interest rate coverage arbitrage (Price convergence arbitrage)
Prices in different markets will move toward convergence. The same issue can help us to predict the price trend of an asset in a market (for example, a digital currency exchange). This is one of the most important arbitrage methods in the digital currency market.
Arbitrage in the futures market
As we said at the beginning of the article, arbitrage can be place or time. Arbitrage in the futures market refers precisely to time arbitrage. Where the price difference between the cash and futures market causes profit. Arbitrage in the futures market is one of the most common arbitrage performed by market participants. Let us explain it with an example:
The price of the precious saffron symbol delivered on the day of writing this article is 36,8047 rials. Its delivery date, as its name suggests, is January 1400. Now, if we know that saffron will be traded at that time for an amount more than this amount plus monthly risk-free interest, this future contract is considered a type of arbitrage.
Coin arbitrage helped
A one-day coin certificate is one of the bonds that are issued on a one-day basis. These bonds can be a good position for arbitrage due to the price difference they may have with the coin price in the market. For example, in the image below, you can see the comparison of the performance of the coin price of the whole spring of one-day delivery of Refah with the price of the coin in the time frames of the last year.
As you can see, they do not match. Below the chart, these two assets are compared.
In this picture, you can see that at least two points marked on the chart have the possibility of arbitrage. Of course, you should pay attention to the fact that the prices should include the cost of keeping the coin, which is charged to you at the time of purchase, as well as the cost of fees.
Arbitrage is one of the methods that can be used to earn profit in the financial markets. Arbitrage is an opportunity to profit from the simultaneous price difference of an asset between two or more markets. In a general definition, arbitrage is divided into “temporal” and “spatial”.
In time arbitrage, you can profit from the price difference of an asset at two different times, and in place arbitrage, the price difference of an asset class in two different places will be profitable. Arbitrage is applicable in many financial markets such as stock market, digital currency and forex.