Arbitrage basics | Finance & Capital Markets | Khan Academy

The word arbitrage
sounds very fancy, but it's actually
a very simple idea. It's really just
taking advantage of differences in price on
essentially the same thing to make risk-free profit. So let's just think
about a little bit. Let's say in one part of town
there's some type of a market. Let's say it's a
market for apples. And let's say in
that market, apples sell for– just
make up some price.

Let's say that apple's in
that market, sell for $1 an apple, $1 per apple. And let's say in another part of
town, you have another market. Another market's
literally a fruit market. And in that other part of town,
apples sell for $1.50 an apple. And we're 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 that's exactly
what you would do. You would go do this market
over here, you would buy apples. Let's 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. You're 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 you'll 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
there's someone who just keeps buying
from this market and selling into that market.

So what's 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 you're going
to make these prices come closer to each other. And eventually, you won't be
able to make any profit at all. But while there's
this discrepancy, you have an opportunity
for arbitrage..

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