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2. When two assets with similar cash
flows are not traded at the same price, there are possibilities
of Arbitrage.
3. When an asset with a known price in future is not traded
today at its future price with a discount from risk-free
interest rate.
Examples
of Arbitrage
1. If the exchange rates in London are £5 = $10 = ¥1000 and the
exchange rates in Tokyo are ¥1000 = £6 = $10, Converting $10 to
£6 in Tokyo and converting that £6 into $12 in London, for a
profit of $2, would be arbitrage. This kind of arbitrage is
called as Triangle arbitrage. Some other complicated foreign
exchange arbitrages like spot-forward arbitrage also exists in
markets.
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2. Another example is from New York
Stock Exchange (NYSE) and Chicago Mercantile Exchange (CME).
When the price of an asset in NYSE and CME are out of time, a
person can buy less expensive one and sell the more expensive
asset. This kind of arbitrage is very risky.
3. By buying some items from the factory outlet and selling them
for higher price through internet or through auctions, we can
easily make profit even though there will be some imbalance
between the two markets.
4. In economics, the term “Global labor arbitrage” refers to the
trend of industrializing jobs in countries where there are low
wages per unit work. Currently such jobs are working out in
China.
Price convergence
Arbitrage has the effect of causing price to converge in
different markets. The Currency exchange rates, the price of
commodities, the price of securities may come together to the
same price in different markets with the effect of Arbitrage.
The market efficiency is measured with the speed at which the
prices converge. With this price convergence, Arbitrage
encourages people to buy assets in the markets where the prices
are low and sell the assets where the prices are high.
Arbitrage moves different currencies towards purchasing power
parity (PPP). PPP is a theory which says that the long-run
equilibrium exchange rate of two currencies is the rate that
equalizes the currencies' purchasing power. For example, A car
purchased in America is cheaper than the same car rate in
Canada. In this case, Americans can bye cars in America and sell
it to Canadians. Canadians have to buy US dollars to buy
American Cars in exchange with Canadian dollars.
Risks
In modern securities markets, very low risks are involved in
arbitrage transactions. In general it is difficult to close two
or three transactions at the same instant; therefore, there are
possibilities that when one part of the transaction is closed, a
quick jump in prices makes it impossible to close the other
transaction at a profitable price.
There are also counter-party risk, that the other party to one
of the transactions fails to deliver as committed one must trade
in order to make a profit on small price differences.
Another risk will occur if the items bought and sold are not
identical. This kind of operation is very risky and will bring
heavy loss.
During 1980, Risk arbitrage (it is a trading plan associated
with Hedge funds) has become very common.
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