Article

Arbitrage
June 07 , 2012

An arbitrage is a type of transaction or portfolio. It is in fact a "free lunch" - a transaction or portfolio that makes a profit without risk. As an example, imagine a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at rupees 51 on one exchange and offered at rupees 50 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a rupee 1.

An arbitrageur is an individual or institution who engages in such arbitrage. A market is said to have no arbitrage - or be arbitrage free - if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed by economic and financial models. Much of the theory of asset valuation is based on the assumption that prices must be set in a consistent manner that affords no true arbitrage between them. This is called arbitrage-free pricing. A market in equilibrium must be arbitrage free.

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