What Is Arbitrage? Definition, Example, and Costs

With foreign exchange investments, the strategy known as arbitrage lets traders lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency across two different markets. This move lets traders capitalize on the differing prices for the same asset in the two disparate regions on either side of the trade.

What Is Arbitrage?

Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. The arbitrage strategy can be used in many markets, including those for trading stocks and those for currency trading.

In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign exchange where the equity's share price has not yet adjusted for the exchange rate, which is in a constant state of flux. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange. This difference positions the trader to harvest gains from this differential.

Although this may seem like a complicated transaction to a beginner, arbitrage trades are quite straightforward and are considered low-risk.

Example of Arbitrage

Consider the following arbitrage example:

TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). First, let's assume the stock trades for $63.50 CAD on the TSX and $47.00 USD on the NYSE. Next, assume the USD/CAD exchange rate is $1.37—meaning that one U.S. dollar equals $1.37 CAD. So, using our share prices from the two markets, the $47 USD share should equal $64.39 CAD on the TSX. But it does not; the current price on the Toronto exchange is less.

Under this set of circumstances, a trader can purchase TD shares on the TSX for $63.50 CAD and simultaneously sell the same security on the NYSE for $47.00 USD. Taking the exchange rate into consideration, the equivalent value of each share should be $64.39 CAD. Ultimately the trader yielded a profit of $0.89 per share ($64.39 – $63.50) for this transaction.

Beware of Transaction Costs

When contemplating arbitrage opportunities, you must consider transaction costs, because if they're too high, they will neutralize the gains from those trades. For instance, in the scenario mentioned above, if the trading fee per share exceeded $0.89, it would nullify any profits.

The Bottom Line

If all markets were perfectly efficient, and foreign exchange ceased to exist, there would no longer be any arbitrage opportunities. But markets are seldom perfect, which gives arbitrage traders a wealth of opportunities to capitalize on pricing discrepancies.