How is arbitrage defined in the financial context?

In the financial context, arbitrage is defined as taking advantage of price differentials to earn risk-free profits. This occurs when an investor simultaneously buys and sells an asset in different markets or forms to profit from differing prices for the same asset. The essence of arbitrage is to exploit inefficiencies in the market, ensuring that prices converge to their fair value.

For instance, if a stock is trading at a lower price on one exchange compared to another, an arbitrageur can buy the stock on the cheaper exchange and sell it at a higher price on the more expensive one. This transaction is considered risk-free, assuming it can be done simultaneously, as any significant delay could expose the arbitrageur to market risk.

Understanding arbitrage is crucial because it plays a vital role in maintaining market efficiency. When arbitrage opportunities exist, they tend to be quickly corrected as traders act on them, which helps align prices across different markets and diminishes the likelihood of sustained price discrepancies.