This refers to the process of purchasing an asset from one market and selling it in another market. Commodities and financial securities are the most common assets which are targeted by swift speculators looking for profits.
While getting into an arbitrage trade, the quantity of the underlying asset bought and sold should be the same. Only the price difference is captured as the net pay-off from the trade.
There is usually at least some risk involved in the process of arbitrage as the price of the asset could change drastically during the time when the speculator holds the asset, imposing huge losses on him. It has been argued that arbitrage helps to allocate assets to their most urgent needs of society, thus improving economic efficiency. Competition between speculators usually lowers the profits from arbitrage over time.
Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion market and at Rs 27,500 in the Mumbai bullion market. A trader may buy 10 gm of gold in Delhi and sell it in Mumbai, making a profit of Rs 500 (Rs 27,500 – Rs 27,000). However, this trade will be profitable only if the cost of transactions is less than Rs 500 per 10 gm of gold.
In the above example, assuming that the total transaction cost, of executing the trades and physical delivery of gold, is Rs 200 for 10gm, then the net profit for the trader would reduce to Rs 300.
If the price difference between the two bullion markets reduces to Rs 200 (or less than that) per 10gm of gold, then the arbitrage opportunity between the two markets shall cease to exist, as the transaction costs shall be equal to, or more than, the price difference between the two markets.