Arbitrage is the ability to make a risk-free profit by
using the price mismatch of an entity in different markets or the mismatch of prices
between commodities that can be traded for each other.
For
an example consider the foreign exchange market: you find that with 1 Euro you can buy
$1.5, and with $1 you can buy 100 Yen. But the number of Yen that can be bought with 1.5
Euro is not 150 but 145. So now you invest $1 to buy 100 Yen. Use the 100 Yen to buy
100/145 = .6896 Euro and use the .6896 Euro to buy $1.0344. So you have been able to
make a 3.44 cent profit for a dollar by just utilizing the mismatch in price of the Yen
and the Euro.
Whenever arbitrage opportunities arise these
are spotted immediately and as people try to use them for their gains the prices quickly
re-align to equilibrium levels due to the supply and demand.
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