Let’s first spend a minute comprehending arbitrage conceptually before moving on to understanding its benefits. Arbitrage is a very well-liked financial tactic that allows an individual, trader, or arbitrageur to earn profit without taking any risks.
It’s crucial to note that this risk-free return may be generated simply by utilizing the price discrepancy between the two marketplaces for the same investment. Although others refer to it as pricing inefficiency, the meaning is the same. In a nutshell, it occurs when the principle of one price is broken. Let’s now discuss the benefits of arbitrage for both investors specifically and markets generally.
1. The fact that there is virtually little risk involved in arbitrage is its major advantage. Arbitration uses hedging techniques to mitigate risk.
2. Arbitrage aids in maintaining securities prices in different markets and market sectors more or less in sync, with disparities explained only by differences in transaction costs. Thus, it may be claimed that arbitrage aids in more accurate asset price discovery and practically eliminates price variations across multiple marketplaces.
3. Arbitrage contributes to the stability and efficiency of the financial markets. For instance, equities would have continued trading at various prices in various markets if there were no arbitrageurs in the market. A small number of merchants would get an unfair edge as a result. To put it another way, arbitrage protects investors' faith in the integrity of the stock market.
4. Arbitrage can be essential in increasing the liquidity in the market. As traders are engaged in quick and simultaneous buying and selling of assets. These simultaneous transactions maintain the cash flow in the market. Finally, arbitrage encourages institutional participation and the adoption of cutting-edge technology, which increases market liquidity.