Arbitrage is the simultaneous purchase and sale of the same asset in different markets (for example Tata Motors stock in NSE and Tata Motors stock in NYSE) in order to profit from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.
Arbitrage arises and exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.
Concept of Arbitrage
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Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-less profit for the trader.
Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds. This whole procedure is carried out using algorithms in complex software which automatically executes the trade whenever any trade-off is alarmed.
Example
As a straightforward example of arbitrage, consider the following. The stock of Tata motors is trading at $22.95 (INR 1710) on the National Stock Exchange (NSE) while, at the same moment, it is trading for $23 on the New York Stock Exchange (NYSE).
A trader can buy the stock on the NSE and immediately sell the same shares on the NYSE, earning a profit of 5 cents per share.
The trader can continue to exploit this arbitrage until the specialists on the NSE run out of inventory of Tata Motors' stock, or until the specialists on the NSE or NYSE adjust their prices to wipe out the opportunity.
Advantages of Arbitrage Pricing Theory (APT)
1. It has fewer restrictions.
The APT does not have the same requirements about individual portfolios as other predictive theories. It also has fewer restrictions regarding the types of information allowed to perform predictions. Because there is more information available, with fewer overall restrictions, the results tend to be more reliable with the arbitrage pricing theory than with competitive models.
2. It allows for more sources of risk.
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The APT allows for multiple risk factors to be included within the data set being examined instead of excluding them. This makes it possible for individual investors to see more information about why certain stock returns are moving in specific ways. It eliminates many of the questions on movement that other theories leave behind because there are more sources of risks included within the data set.
3. It does not specify specific factors.
Although APT does not offer specific factors like other pricing models, there are four important factors that are taken into account by the theory. APT looks at changes in inflation, changes in industrial production, shifts in risk premiums, and shifts in the structure of interest rates when creating long-term predictive factors.
4. It allows for unanticipated changes.
APT is based on the idea that no surprises are going to happen. That is an unrealistic expectation, so Ross included an equation to support the presence of an unanticipated change. That makes it easier for investors to identify assets which have the strongest potential for growth or the strongest potential for failure, based on the information that is provided by the opportunity itself.
5. It allows investors to find arbitrage opportunities.
The goal of APT is to help investors find securities in the market that are mispriced in some way. Once these can be identified, it becomes possible to build a portfolio based on them to generate returns that are better than what the indexes are offering. If a portfolio is then undervalued, the opportunities can be exploited to generate profits because of the changes in the pricing theory.