February 07, 2006
From the Classroom: What is Arbitrage?
Arbitrage is commonly used to denote risk-free trading. The idea behind arbitrage is to take advantage of any price differential between two markets by buying from one and selling in the other. Arbitrage in its pure form is risk free and often called as True Arbitrage. It is generally the market makers who are able to use true arbitrage as they have the necessary capital and resources to invest in large amounts and make use of these opportunities.
Retail traders are not able to indulge in true arbitrage for lack of large amount of capital. They generally take to trading in risk arbitrage, also known as statistical arbitrage. Risk arbitrage arise out of situations where a price difference occurs due to an event whose happening is subject to uncertainty. Examples of such an event would be a merger or a takeover which may or may not take place but which may lead to price fluctuations. The different types of risk arbitrage are Merger and Takeover Arbitrage, Liquidation Arbitrage, and Pairs Trading also known as relative-value arbitrage. Investopedia reports:
Arbitrage, however, can take other forms. Risk arbitrage (or statistical arbitrage) is the second form of arbitrage. Unlike pure arbitrage, risk arbitrage entails--you guessed it-- risk.
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