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Saturday, September 19, 2015

Concept of Arbitrage

Arbitrage is the practice of taking advantage of the 'price-difference' for a homogeneous commodity or a security in two or more markets by buying from the market where the price is low and simultaneously selling it in the market where the price is high. 


Arbitrage is possible only when the profits made by buying and selling the same commodity or security in two different markets is large enough to cover the transaction costs involved in the trade.

Let us understand the concept of arbitrage with the help of an example. 

A Ltd. is listed in both the BSE and NSE. At 11 am, the security is trading at NSE for 510. While at BSE the price for the same is 500. If you buy 1 share of A Ltd. from BSE @ 500 and simultaneously sell it at NSE @ 510, your profit is Rs. 10. 

The above example assumes that there are no transaction costs involved. However if there are brokerage costs involved for both buying and selling, the situation would be quite different.

Now let us assume that the transaction involves a brokerage cost of Rs.5 per share either way. A buy and sell transaction would involve a brokerage of Rs. 10. In this case, the profits made would be wiped out by the cost of brokerage involved.


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