What does arbitrage

What does arbitrage mean?

What should one know about arbitrage?

In order to fully understand the meaning of arbitrage, one should still know some specifics of this business model.

Arbitrage is theoretically risk-free.

Arbitrage is completely risk-free in theory. You buy a cheap product and sell it at the same time at a higher price. In principle, nothing can go wrong with this.

In practice, however, this assumption does not work.

Some steps are necessary for both the purchase and the sale (e.g. concluding sales contracts), so that delays can occur. So there is a certain risk that the prices will change again in between. Even on the stock exchange, where fast transactions are common, something can come up.

Arbitrage deals are always short-term.

The risk of arbitrage business arises primarily from the second property: Arbitrage is basically only possible at very short notice. This characteristic can be explained as follows:

If I buy a lot of products at low prices in the first market, the prices there will go up. After all, demand is skyrocketing, so providers will certainly respond to it.

Conversely, many more products are suddenly being sold on the second market with the high prices - the supply increases. A large supply, in turn, leads to lower prices as the competition has increased.

In the end, the prices of the two markets adjust again. This also means that the opportunity for arbitrage business is gone.

Arbitrage can also be borrowed.

In order to make high profits through arbitrage, you need a lot of seed capital. After all, the products must first be bought before they can be sold at a high price.

It is therefore conceivable and quite common to finance the purchases with loans. This option is particularly tempting because the arbitrage deals theoretically do not involve any risk.

As we have seen above, however, the practice also sees it differently. Correspondingly, the financial risk increases with credit-financed arbitrage, since the arbitrage profits also have to cover the interest costs.

Arbitrage is becoming more and more difficult on the stock exchanges.

Arbitrage only works when as few people as possible know about the current price differences. As soon as many traders take advantage of the arbitrage, the prices level out and the chance is wasted.

In the modern world of stock exchanges, there is a great deal of technology at work that is searching for arbitrage. If it is found, the corresponding purchases are automatically triggered. This makes manual arbitrage extremely difficult.

Arbitrage business: which variants are conceivable?

In order to break down the very broad meaning of arbitrage a little, a distinction is made between different variants. The main categories are as follows:

Spatial arbitrage

In this variant, the product is traded on two markets, the geographically separated from each other are. For example, you could buy a product cheaply in Asia and sell it at a higher price in Europe. The condition is, however, that the arbitrage profits are not destroyed again by transport costs etc.

Cultural arbitrage

This model is somewhat similar to spatial arbitrage, but with a different focus. In the case of cultural arbitrage, this is exploited a product has a high value in some cultures, while elsewhere it is only viewed as an inferior product.

Cultural arbitrage is conceivable in the area of ​​food, for example: while food is abundant in one culture and only classified as a basic resource, it could be considered a rare delicacy in a second culture.

Temporal arbitrage

The form of temporal arbitrage is strictly speaking no real arbitrage. By definition, an arbitrage deal is risk-free because you buy and sell at the same time. In contrast, temporal arbitrage assumes that the prices for a certain product will change in the future.

Find with it No longer buying and selling at the same time instead of. The risk is also significantly higher in this case, as prices could develop unexpectedly.

Arbitrage: example stock trading

A common use case in practice is the stock exchange transaction. The arbitrage can be imagined as follows:

A stock trader buys securities on the New York Stock Exchange at a rate of EUR 7.50 - we omit the different currencies for the sake of simplicity. At the same time, he sells exactly the same securities on the Frankfurt Stock Exchange. There the rate is currently at 8.00 euros.

Through the arbitrage business, the dealer makes a profit of 0.50 euros per piece. If he buys securities worth 1.5 million euros, that makes a profit of 100,000 euros.

At the same time, the price adjustment begins: In New York, demand has increased due to the arbitrage business. The price rises accordingly, let's say to 7.75 euros. At the same time, the price in Frankfurt falls, as suddenly there is a very large offer. There, too, there is a new rate of 7.75 euros.

Once prices have leveled off, arbitrage is no longer possible.

Arbitrage: example of commodity trading

Let's imagine a merchant who deals in groceries. For him, an arbitrage business could look like this:

The dealer buys meat from a European slaughterhouse. Since meat and sausage are standard on the dining table in this country, the prices are 15 euros per kilogram. He then ships the food to various emerging countries. Meat is rarer and more valuable there, so that it can call a price of 30 euros per kilogram.

So he achieves a gross profit of 15 euros per kilogram of meat. Various costs (e.g. for transport) must then be deducted from this. In the end, there is still a classic arbitrage win.

In this case, it is a question of spatial and, to a certain extent, also cultural arbitrage.