What are Arbitrage operations?
What are Arbitrage operations?
Arbitrage is the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on the exchange-rate differentials in various markets.
The arbitrage opportunities exist due to the inefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, the price differential is captured as a trade’s net payoff. This payoff should be large enough to cover the expenses incurred in executing the trade.
For example: Suppose the stock of company A is trading at Rs 2000 on BSE while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of Rs 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity.
The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets.
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