An arbitrage is a type of transaction or portfolio. Actually, the term is used in two different ways, so it refers to either of two very different types of transactions or portfolios. People also speak of arbitrage as an activity—the activity of seeking out and implementing either of the two types of arbitrage transactions or portfolios. An arbitrageur is an individual or institution who engages in such arbitrage. In finance theory, an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02. Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.
Formally, theoreticians define an arbitrage as a trading strategy that requires the investment of no capital, cannot lose money, and has a positive probability of making money. A market is said to have no arbitrage—or be arbitrage free—if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed for markets in economic and financial models. The assumption underlies the financial engineering theory of arbitrage-free pricing. Turning now to the second use of the term arbitrage, it is a usage that is shunned by theoretical purists. However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an arbitrage is a leveraged speculative transaction or portfolio. During the 1980s, junk bond financing funded an overheated mergers and acquisitions market. Arbitragers of this period were speculators who took leveraged equity positions either in anticipation of a possible takeover or to put a firm in play. They also engaged in greenmail. Ivan Boesky was a famous arbitrager from this period who was ultimately convicted of insider trading. Today, the label arbitrage is often applied to the speculative trading strategies often associated with hedge funds. These include To distinguish between the two definitions of arbitrage, we might call them "true" arbitrage and "speculative" arbitrage. They are different, but in a sense they represent, two ends of a spectrum. In practice, true arbitrage is rare. There is always some risk—perhaps due to liquidity, the timing of offsetting transactions, or perhaps some credit exposure. If these "true" arbitrages become increasingly complicated or sophisticated, the subtle risks multiply. From there, it is a slippery slope to "speculative" arbitrage. The notion of true arbitrage is profoundly important in financial engineering and theoretical finance. In theory, a market in equilibrium will offer no arbitrage opportunities. Much of the theory of asset valuation is based on the assumption that prices must be set in a consistent manner that affords no true arbitrage between them. This is called arbitrage-free pricing.
In practice, people don't write about true arbitrage or speculative arbitrage. They just write about arbitrage. It is up to the reader to infer from context what type of arbitrage is being referred to. In a theoretical or financial engineering context, this is usually true arbitrage. In a trading or portfolio management context, it is usually speculative arbitrage. In a risk management context, it could be either—ask. People from fields other than finance or economics sometimes confuse the two forms of arbitrage. I once helped a professor from an unrelated field who was writing a paper that mentioned arbitrage. He had read about the profound importance of arbitrage in finance theory but thought this was referring to the speculative arbitrage he had read about in books on hedge funds. Journalists are notorious for confusing the two. A former colleague, Kin Tam, once commented to me that journalists "write about arbitrage as if it were something unconscionable."
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