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Options, swaps, futures, MBSs, CDOs, and other derivatives

Options, swaps, futures, MBSs, CDOs, and other derivatives

The word arbitrage sounds very fancy, but its actually a very simple idea. Its really just taking advantage of differences in price on essentially the same thing to make risk-free profit. So lets just think about a little bit. Lets say in one part of town theres some type of a market. Lets say its a market for apples. And lets say in that market, apples sell for– just make up some price. Lets say that apples in that market, sell for $1 an apple, $1 per apple. And lets say in another part of town, you have another market. Another markets literally a fruit market. And in that other part of town, apples sell for $1.50 an apple. And were going to assume that these apples are completely identical apples. How could you take advantage in this price difference on these identical things to make a risk-free profit? Well ideally, you would want to sell apples in the more expensive market where you could get $1.50 per apple. And you would want to buy apples in the less expensive market where you can get them for $1 per apple. And thats exactly what you would do. You would go do this market over here, you would buy apples. Lets say you buy 10 apples for $10. And then you would go maybe ride your bicycle a couple of blocks to that other market over there. And you would sell your 10 apples. So this is buy 10 apples for $10. And then you would sell those 10 apples for $15. And so you would make an immediate risk-free profit of $5. Youre buying for 10, selling at 5. And you could just keep doing that over and over again. And on every trip as many apples as your bicycle could carry youll just continue to make money. And so this is what arbitrage is. And just imagine a side effect. If someone did this enough, then what would do is it would increase the supply of apples here. So supply would increase in this market. And on this market, the demand would increase because theres someone who just keeps buying from this market and selling into that market. So whats eventually going to happen when demand increases, the price will go up in this market. And when the supply increases in this market, the price will go down. So in theory, the more you do this, the more that youre going to make these prices come closer to each other. And eventually, you wont be able to make any profit at all. But while theres this discrepancy, you have an opportunity for arbitrage.