What Is Arbitrage?
[Q:] What is arbitrage? What markets do arbitrageurs usually trade on?
[A:] Terrific question! Let's start from the definition. The Economics Glossary defines arbitrage opportunity as "the opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price." If I can buy an asset for $5, turn around and sell it for $20 and make $15 for my trouble, that is arbitrage.
The $15 I gain represents an arbitrage profit.
Arbitrage profits can occur in a number of different ways. We'll look at a few examples:
One Type of Arbitrage - One Good, Two MarketsSuppose Walmart is selling the DVD of Shaft in Africa for $10. However, I know that on eBay the last 20 copies of Shaft in Africa on DVD have sold for between $25 and $30. Then I could go to Walmart, buy copies of the movie and turn around and sell them on eBay for a profit of $15 to $20 a DVD. It is unlikely that I will be able to make a profit in this manner for too long, as one of three things should happen:
- Walmart runs out of copies of Shaft in Africa on DVD
- Walmart raises the price on remaining copies as they've seen an increased demand for the movie
- The supply of Shaft in Africa DVDs skyrockets on eBay, which causes the price to fall.
There are costs to this however. First of all, you don't find rare Colecovision games just lying around, you have to spend time and energy looking for them. Secondly, you have to spend time learning what is valuable and what is not valuable so you don't find out later what you thought was worth $100 is only worth $5. Lastly, just because something has sold for $100 in the past does not mean it will sell for $100 again in the future. So given both the financial costs and the opportunity costs involved, we would expect arbitrageurs on this market to make as much money as they would doing other productive activities that require the same set of skills.
One Good, Two Markets Arbitrage in Sports GamblingArbitrage of the "One good, Two markets" variety is quite common in the world of sports gambling. Arbitrage on the sports market exists because different betting agencies often post different odds on the outcome of a game. Suppose the White Sox are playing the Red Sox. Bookmaker Billy is giving even money on the game, so a $100 bet placed on either team will earn you $100 if the team you picked wins. Sportsman Steve has the White Sox at +200, which means if you place a $100 bet with Steve on the White Sox to win, you will get $200 if they win, and $100 if they lose. You can guarantee yourself a profit if you make the following bets:
- Place a $300 bet on the Red Sox with Billy at even odds.
- Place a $200 bet on the White Sox with Steve at +200.
Profit if the Red Sox Win
Profit if the White Sox WinSource: economics.about.com