In this lesson we will learn about arbitrage. We will discuss the law of one price and examine examples of arbitrage opportunities. We will then conclude the lesson with a summary and a quiz.
An Introduction to Arbitrage
Imagine you find a mint condition My Little Pony from 1985. Let's be honest: you've always loved My Little Pony and when you finally find the pink pony with rainbow hair from 1985, you determine that you must have it. The pony you find is in Denver, Colorado, and the seller is asking $55 for it. It's obviously a lot of money for a toy pony, but come on: you really want it! Before making the final bid for the pony, you decide to do some research and find out if the price you are about to pay is a fair price. It was at that time, since you find the exact same pony in Dallas, Texas going for $110. You soon realize that you can by the pony in Denver and then sell it in Texas for a profit without risk because the price is guaranteed in Dallas. What you've just experienced is an arbitrage opportunity.
I'm sure by now you have figured out that arbitrage has something to do with buying and selling an item, but is there more to this term? The answer is yes. Arbitrage is buying in one market while at the same time selling in another market. In other words, it's the act of buying something at a low price and then selling it on a different market right away at a higher price. Because you generate a profit, you're essentially getting paid for your trouble due to the difference in price.
The Law of One Price
While making a profit is an ideal situation for anyone in the business of buying and selling of items, how long can one expect to continue making a profit by means of an arbitrage opportunity? What happens when others learn about the opportunity to make money buying and selling the same item?
This is where the law of one price comes into play. This term means that assets have the same value everywhere especially where financial markets are concerned. Because of the law of one price, one can only expect to generate a profit for a short amount of time. This is due to the fact that others will immediately follow your lead and buy at low prices and sell at high prices. This results in either a shortage of the item everyone is selling, or will lead to a reduction in the value of the item because there is an abundance of them and it is not as rare as before. The bottom line is if you have an opportunity to make money by buying low and selling high, other people will learn of this opportunity and do it too, indicating that one should act fast.
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Bill decides to go to a garage sale on his weekend off. While there, he finds a rare gemstone with a price tag of only one dollar. Bill knows that the gemstone is worth much more than the $1 price tag at the garage sale. Bill decides to buy the gemstone and attempt to sell it on eBay. While listing the gemstone. Bill searches for similar ones on eBay and realizes that he can sell his for $50. Bill sells his gemstone for $50 and makes a $49 profit.
Bill decides to go back to the garage sale the next day to see if there are any more gemstones available to purchase. Bill finds out that other people had the same idea of purchasing the gemstones at a low price and selling them at a high price. This results in a shortage of the available gemstones. It also results in a lower profit because eBay soon had many of the exact gemstones available for purchase making them less rare and allowing shoppers to wait until the gemstones was offered at a cheaper price.
Bill realizes that he should have purchased all of the gemstones at one time so that he could have continued to make a profit. Bill has just been introduced to an arbitrage opportunity.
Arbitrage is the act of buying something at a low price and then selling it at a higher price. This act generates a profit and usually results in little risk. Because others are probably going to learn about the profits that can be made by participating in similar buying and selling acts, the opportunity to make a profit is usually pretty short lived.
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