Arbitrage is the process of taking advantage of the mis-pricing securities or a price difference between two or more markets. Suppose that the exchange rates between the Euro, US Dollar and Singapore Dollar are as follows:

EUR -USD – 1.4808(buy), 1.5008(sell)

EUR-SGD – 2.0975(buy), 2.1175(sell)

USD-SGD – 1.4472(buy), 1.4672(sell)

This essentially means that the Foreign Exchange firm (say Thomas Cook or ICICI) will sell 1 EUR for 1.5008 USD and buy 1 EUR for 1.4808 USD and so on…

If I do the following:

1. Buy Euros with 1 million SDG. I would have 1,000,000 /2.1175 = 472,257 EUR

2. Buy USD with my 472,257 EUR. I would have 472,257 * 1.4808 = 699,315 USD

3. Buy SGD with my 699,332 USD. I would have 699,315 * 1.4472 = 1,012,048 SGD

Thus, I would have made a risk-free profit of 12,048 SGD !

Obviously, in this case there is some mis-pricing in the market. These prices are not real prices. The spreads between ” buy and sell ” are generally higher in the real world and the prices are such that there is no scope for this kind of arbitrage. In the previous The EUR-USD rate is higher than it should be.

These kinds of situations are rare.However, they do occur. That is when hedge funds and algorithmic traders take advantage of such mis-pricing to make a risk free profit. The market eventually corrects itself when the prices rise in response to the increased demand, thereby correcting the price differential.

Example of Arbitrage in the day to day world

A certain cookie outlet sells cookies at 77 cents each (for students). Thus, when you order 1 cookie, you are charged 77 cents which is rounded off to 75 cents. However, when you buy 2 cookies, you are charged 77 * 2 = 154 cents. This amount is rounded off to 155 cents i.e $ 1.55

Thus, theoretically speaking, if you place an order for 1 cookie 1000 times, you end up paying 750$. You can package these cookies into pairs of 2 and sell them to subway customers at $1.55 per package thereby earning 1.55*500 = $775 , thus making a profit of 25 $. This is of course, assuming that you don’t get bulk discount and that you can find customers who want to buy packages of 2 cookies and the continuation of the price differential in question.

Ok, I am not suggesting even for a moment that someone should actually go and do this.Rather, I am illustrating the concept of arbitrage.

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