Arbitrage a kind of hedged investment meant to capture slight differences in price. When there is a difference in the price of something on two different markets the arbitrageur simultaneously buys at the lower price and sells at the higher price.
Simply said it is a type of stock trading done by buying a product in one market and selling the same product in another market simultaneously to avoid market risk.
But, it is not as simple as that. It is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, 'arbitre' usually means referee or umpire).
An arbitrageur, one who engages in arbitrage, takes advantage of price difference of a product in two different markets. When ever a price difference exists in a two different markets, he buys a product (bonds, stocks, derivatives, commodities or currencies) in one market at a lower price and almost instantaneously sells the same product in a different market at a higher price by matching profitable deals.
At any time it should not involve negative cash flow, so that it will be a risk free profit. He makes profit only if the transaction costs of buying, holding and reselling are small relative to the difference in prices in different markets.
"True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.
It involves huge capital investment, fast and efficient management of large data and information. This needs sophisticated software and computers.
Arbitrage is possible when one of three conditions is met:
It has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency.
Thus arbitrage helps market work efficiently.