Arbitrage is a form of trading that is either riskless or close to riskless.  It also involves both buying and selling of similar investments at the same time, which is a form of hedging.  For the novice to understand, he or she must first be made aware of the concept of short selling.  Short selling of securities, commodities or other things involves borrowing the thing from someone who owns it, agreeing to return the physical borrowing at a later date, and selling it, now, in the market.  The use of pure short sales is based on the expectation that the price will decrease.  In that regard, I borrow 100 shares of ABC stock and sell it short at $40.  Then, a month later, I buy it back at $30 and return the stock loan.

The practice of arbitrage was invented in currency trading by the Venetians about 500 years ago.  Since Venice was an international port, money from different countries was exchanged.  It may be possible to make a profit ,if, through a series of transactions among successive pairs of currency of which the original currency is all the final one, you can end up with more of that currency than you started with.  In general, arbitrage involves simultaneous buying and selling of similar things, making a spread between the buy and sell price.  We buy a long position and usually sell short the counterbalancing. It can also involve different markets, like selling the implied rate of return on stocks and buying the return of generic bonds because you think that the interest rate spread between stock and bond returns is too great.

In fact, arbitrage  is usually extant because of barriers to entry, which means market inefficiency. For example, when I was in merger arbitrage, in the 1980's, there were barriers to entry due to expertise in corporate and antitrust law, executive behavior, valuation, and even amount of capital to be able to pay for that expertise.  Thus, to be normal in the business, you needed around $100 million in capital.

As a quantum physicist I first became enamored with the concept of arbitrage because it reminded me of certain virtual interactions in particle physics.  The way I look at arbitrage is quite broad.  For example, I view commission business by brokers, in securities, as an arbitrage because the broker makes a spread, his commission, by hooking up a buy side and a sell side, even though he does not physically simultaneously buy and sell.

Indeed, the whole export phenomena of China over the last decade or so has been purchasing power arbitrage between what the Yuan can buy versus what foreign currencies can buy, against the background that the Yuan has been purposely fixed at too low a price by the central bank against foreign currencies, specifically to promote exports, while also impeding imports.  We recently wrote a report about that on the In Country Analysis page of our website where we also have a longer paper that discusses the arbitrage concept in greater detail and example.