Arbitrage: Getting Something For Nothing?
Arbitrage is the term used by economists to describe a specific kind of market maneuver wherein something is bought and then resold in another market at a profit. Arbitrage is only possible when the same item is selling for two different prices in two different places. This sometimes happens when a stock is on both the New York Stock Exchange and the Chicago Mercantile Exchange, for example, but can also happen in more familiar scenarios, such as when two local department stores are selling the same dress at different prices. If a broker buys a stock at the lower price and then sells it in the other market at the higher rate, turning a profit; that is known as arbitrage. If you were to buy the dress for the lowest price in town and then return it for a cash refund to a retailer where the dress costs more so that you could pocket the difference, you would be engaging in arbitrage.
Arbitrage is practiced on a large scale by certain investment firms, but it also has a place in everyday scenarios familiar to most of us. Arbitrage is the financial backbone of many ebay stores, as sellers often buy wholesale goods in bulk from factory warehouses or outlets and then auction the goods off over the Internet at a profit. There is a common scam that takes place wherein young people will buy up candy bars in bulk and then sell them door to door, claiming the proceeds will go to a charitable organization or will help to fund a school trip. In many cases, what is taking place in these transactions isn’t charity after all, but simple arbitrage.
According to economic theory, arbitrage is by its nature a temporary way to make a profit, a kind of profitable loophole in the global pricing system for those lucky enough to find it. Over time, price convergence takes effect, and the discrepancy between the prices in one market and the other disappears. The sudden influx of a stock on the CME or the NYSE will destroy the scarcity that raised the price, causing the prices of stocks on the two markets to even out. One retailer will notice that the store across town is selling the dress for more money, and will raise the price in order to turn a larger profit. However, for those who are eagle eyed enough to catch an opportunity for arbitrage, the rewards can be quite substantial.
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