Arbitrage is a way of exploiting differences by seeking absolute economies rather than the scale economies gained through standardization. It treats differences across borders as opportunities, not as constraints. The word arbitrage itself comes from the French word for judgment; a person who does arbitrage is an arbitrageur. The idea is that the arbitrageur arbitrates among the prices in the market to reach one final level
The term “arbitrage" is used by economists to describe a process by which traders attempt to exploit price differentials in various financial markets. Arbitrage can be used in a variety of ways, but it usually involves differentials in interest rates, securities prices, commodity prices, foreign exchange rates, and gold and silver prices. The arbitrager attempts to purchase lower priced assets in one market and then almost instantaneously sell them, usually electronically in another market. Although the practice of arbitrage has been going on for a long time, the rise of computers and electronic communications in a global financial market has put a premium on speed and the rapid processing of buy and sell orders. Even momentary delays can have catastrophic consequences for arbitrage investors.
In theory, arbitrage is riskless. It’s illogical for the same asset to trade at different prices, so eventually the two prices must converge. The person who buys at the lower price and sells at the higher one will make money with no risk. The challenge is that everyone is looking for these easy profits, so there may not be many of them out there.
True arbitrage involves buying and selling the same security, and many day traders use arbitrage as their primary investment strategy. They may use high levels of leverage (borrowing) to boost returns. Other traders follow trading strategies involving similar, but not identical, securities. These fall under the category of risk arbitrage.
The "risk arbitrage" appeared in the United States ln the 1980s. Risk arbitrage is essentially a form of stock speculation in which an investor anticipating a corporate merger or takeover of one company by another, purchases stock in the company to be taken over. Since a takeover will usually drive up the price of the company’s stock, huge profits are possible
If you are interested to apply the arbitrage strategy make sure that you understand the CAGE framework in order to broaden the set of arbitrage opportunities under consideration. The four dimensions of the CAGE framework focus on distinct categories of differences and therefore supply distinct bases for arbitrage.
Favorable effects related to country or place of origin have long supplied a basis for cultural arbitrage. For example, French culture or, more specifically, its image overseas has long underpinned the international success of French haute couture, perfumes, wines, and foods. But cultural arbitrage can also be applied to newer, more plebian products and services. U.S. fast food chains present a relevant counterpoint. Nor are such “countryof-origin” advantages reserved for rich nations.
Administrative Arbitrage
Legal, institutional, and political differences from country to country open up another set of strategic arbitrage opportunities. Tax differentials are, perhaps, the most obvious example – note the importance of enclaves, tax havens, free-trade areas, and export processing zones in firms’ decisions about plant locations and financial structure. Companies also exploit regulatory differences to locate production where environmental and labor laws are advantageous. However, administrative arbitrage is another area that requires a strong legal and ethical warning. While much of what goes on under the rubric of administrative arbitrage is legal or at least semi-legal, some of it clearly has an odor to it – requiring serious ethical as well as legal review.
Geographic Arbitrage
Considering all that has been said and written about the “death of distance,” it is perhaps predictable that few strategy gurus take geographic arbitrage very seriously. Yes, it’s true that transportation and communication costs have dropped sharply in the last few decades. But that drop does not necessarily translate into a decrease in the scope for geographic arbitrage.
Economic Arbitrage
In a sense, all arbitrage strategies are “economic.” But the term is used here to refer to the exploitation of economic differences that don’t derive directly from cultural, administrative, or geographic differences. These factors include differences in costs of labor and capital, as well as variations in more industry-specific inputs (such as knowledge) or in the availability of complementary products. The best-known type of economic arbitrage is the exploitation of labor cost differentials, which is common in labor-intensive and capital-light manufacturing (e.g. garments). However, some high tech companies have also been able to take advantage of labor cost arbitrage to access highly skilled workers at lower cost.