That is what I will attempt to explain in this piece. An Excel calculator is provided below so that you can try out the examples in this article. Arbitrage and Value Trading Are Not the Same Arbitrage is the technique of exploiting inefficiencies in asset pricing. When one market is undervalued and one overvalued, the arbitrageur creates a system of trades that will force a profit out of the anomaly. In understanding this strategy, it is essential to differentiate between arbitrage and trading on valuation. Buying an undervalued asset or selling an overvalued one is value trading. The true arbitrage trader does not take any market risk.
He structures a set of trades that will guarantee a riskless profit, whatever the market does afterwards. Arbitrage Example Take this simple example. Suppose an identical security trades in two different places, London and Tokyo. For simplicity, let’s say it’s a stock, but it doesn’t really matter.
The table below shows a snapshot of the price quotes from the two sources. At each tick, we see a price quoted from each one. At 8:05:02 the arbitrageur sees that there is a divergence between the two quotes. London is quoting a higher price, and Tokyo the lower price.