Arbitrage is the technique of investing in two assets (going long one and short the other) and assuming that the prices will converge over time. This is made possible as a result of market inefficiencies, although as technology advances more and more these inefficiencies are likely to be smaller and to be eliminated faster.

True arbitrage is meant to be risk free profit but in reality it very very rarely is. Due to the fact that any profit from arbitrage is likely to be small, traders and investors will put in vast amounts of money to magnify returns.

The most famous example of arbitrage is that of Long Term Capital Management, the quant-based hedge fund which started off selling new US government bonds and buying older ones, and taking the profits as the prices converged. Hedge funds which operate an event driven strategy will often work on the basis of merger arbitrage, i.e. that the stock prices of companies will converge if they complete a merger deal.

Related Terms

• Efficient Market Hypothesis (EMH)
• Hedge Fund (HF)
• Leverage
• Quant

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