Arbitrage is the execution of a number of transactions to create a risk free profit. To be pure arbitrage, there must be no risk at all and the transactions must be simultaneously executed. In the world of instantaneous communications and cyber trading, arbitrageurs have found it more and more difficult to exploit situations, simply because markets are getting more efficient due to geographical, technological and communication barriers being removed to a large extent.

Theoretically, arbitrage occurs when an asset trades at one price and simultaneously trades at another. As markets have become increasingly regulated and specifically standardized, without more, it is rare for this to occur.

Another manner in which arbitrage can occur is when cash flows are required to price an instrument or commodity, and the same assets with the same cash flows are available at different prices. Related to the concept of cash flows, if a price of something in the future is certain, and it is able to be acquired in the present and dealt with for contingencies at a price that is different to the future price, arbitrage is possible.

These opportunities quickly disappear in efficient markets such as those operating today, however often they are available to those willing to invest resources into their acquisition. If complex calculations are required, even software is only as good as its inputs and so the more accurate and timely the inputs, the more opportunity to exploit arbitrage opportunities. Further, physical handling of assets may require logistical resources and if these are precise and reliable then they represent no risk and can be efficiently enlisted into the arbitrage sequence.

In simple terms if the cost of an ounce of gold cost US$1000 with delivery due in 6 months time, if it is possible to buy gold now at US$800 and it only costs US$100 to transport it and store it securely until that time, a profit of US$100 would accrue. Again, if A$100 can be exchanged for US$60, and that US$60 can be exchange for €80, if that €80 can be again exchanged for more than A$100, a profit will be realized.

Some forms of arbitrage are not the classic form described above, as they involve the operation of other variables which either would not be available ordinarily to all participants (such as information the quality of which is a risk in itself), or the execution of transaction in assets that are similar but not exactly the same. While risk in these investments may well be reduced infinitely, theoretically a risk is still apparent and therefore the transaction is not imbued with the features of classic arbitrage.

This article was provided by George Acheson - he writes on a variety of subjects including the debt management process in the UK.