Arbitrage refers to buying an instrument or a commodity in one market and simultaneously selling it in another, making clear and risk less profit. Arbitrage opportunities are available when markets are not efficient. A person who makes risk less profit by using market inefficiencies is called an arbitrager.

Consider a 1 year maturity bond with face value of Rs100, coupon rate of 10%, paying coupon semi annually and bank interest rate is 5% pa.

Present value of the cash flows from this bond is

5/1.025 + 105/(1.025)2 = 104.82

If price of this bond is Rs100 in the market, one can borrow Rs100 from a bank and buy this bond.He will be able to pay Rs5 once he receives first coupon on this bond. By this time his outstanding amount will be 97.5 (100+100*2.5/100 - 5). At the end of one year he will receive Rs105 (principal + last coupon) which can be used to pay bank’s debt of Rs99.94 (97.5*1.025). He will make risk less profit of Rs 5.06

To exploit this situation every one tries to buy this bond by borrowing from banks to get risk less profit. As the demand for this bond increases the price also increases gradually to an extent that there won’t be any arbitrage opportunity. This happens in very less time in an efficient market giving less time for arbitragers to act.

Author's Bio:

Satya, Editor of lastbull.com/