Arbitrage is the one of the basic concepts in finance. It is defined when a person or company simultaneously purchases and sales shares of a company or other investment instruments in two separate markets for taking advantage of perceived mispricing. Theoretically speaking, this is a guaranteed way to produce risk-free profits and require no capital, but is hardly worth it unless millions of dollars are involved. In reality, almost all arbitrage require capital and typically risky. The above case described in question 1, as made by Milton Friedman (1953) and Fama (1965), is based on arbitrage.
It is one of the most intuitively appealing and plausible arguments in all of economics. A textbook definition (Sharpe and Alexander 1990) defines arbitrage as ‘the simultaneous purchase and sale of the same, or essentially similar, security in two different markets at advantageously different prices. ‘ Suppose that some security, say a stock, becomes overpriced in a market relative to its fundamental value as a result of correlated purchases by unsophisticated, or irrational, investors.
This security now represents a bad buy, since its price exceeds the properly risk adjusted net present value of its cash flows or dividends. Noting this overpricing, smart investors, or arbitrageurs, would sell or even sell short this expensive security and simultaneously purchase other, ‘essentially similar,’ securities to hedge their risks. If such substitute securities are available and arbitrageurs are able to trade them, they can earn a profit, since they are short expensive securities and long the same, or very similar, but cheaper securities.
The effect of this selling by arbitrageurs is to bring the price of the overpriced security down to its fundamental value. In fact, if arbitrage is quick and effective enough because substitute securities are readily available and the arbitrageurs are competing with each other to earn profits, the price of a security can never get far away from its fundamental value, and indeed arbitrageurs themselves are unable to earn much of an abnormal return. A similar argument applies to an undervalued security.
To earn a profit, arbitrageurs would buy underpriced security and sell short essentially similar securities to hedge their risk, thereby preventing the underpricing from being either substantial or very long-lasting. The process of arbitrage brings security prices in line with their fundamental values even when some investors are not fully rational and their demands are correlated, as long as securities have close substitutes. Therefore equalize the relative prices and bring the market to efficiency under efficient market hypothesis (EMH). Arbitrage has a further implication.
To the extent that the securities that the irrational investors are buying are overpriced and the securities they are getting rid of are underpriced, such investors earn lower returns than either passive investors or arbitrageurs. Relative to their peers, irrational investors lose money. As Friedman (1953) points out, they cannot lose money forever: they must become much less wealthy and eventually disappear from the market. If arbitrage does not eliminate their influence on asset prices instantaneously, market forces eliminate their wealth.
In the long run, market efficiency prevails because of competitive selection and arbitrage. It is difficult not to be impressed with the full range and power of the theoretical arguments for efficient markets. When people are rational, markets are efficient by definition. When some people are irrational, much or all of their trading is with each other, and hence has only a limited influence on prices even without countervailing trading by the rational investors.
But such countervailing trading does exist and works to bring prices closer to fundamental values. Competition between arbitrageurs for superior returns ensures that the adjustment of prices to fundamental values is very quick. Finally, to the extent that the irrational investors do manage to transact at prices that are different from fundamental values, they only hurt themselves and bring about their own demise. Not only investor rationality, but market forces themselves bring about the efficiency of financial markets.