The arbitrage was established to increase the efficiency in trading by buying and selling of the assets simultaneously. Examples would be buying stocks from one exchange and simultaneously selling it on the other exchange that has a higher price for the same asset resulting in profit and eliminating any fluctuation in the price.
The above mentioned is a simple example of arbitrating. In Another example, we will see triangular arbitrage which is a little more complicated than the above example and how triangular arbitrage can be used to gain profits. In this type of arbitrage the trader will have one type of currency which he will be converting into another form of currency at the first bank, further he will be converting this currency again into another form of currency in the second bank and finally the third type of currency is converted back to the first type at another bank. The trader does so because once you convert currency in a particular bank they will have it in their records so that the rates of the currency are in alignment, therefore, to implement this type of strategy different types of financial establishment is required.
Arbitration can also have another form that is the risk arbitrage. The risk arbitrage is also known as strategic arbitrage which is the second form of arbitrage. As the name suggests risk arbitrage has risks involved in it unlike the pure type of arbitrage. In spite of all the speculations done on this type of arbitrage, it has still become one of the popular forms of arbitrating as it is retail friendly so people who trade in retail make use of it a lot.
Let us consider an example and see how it actually works:
Say that there are two companies by name company X and company Y. The first company that is company X is trading at $20 per share at present and the company Y wants to take over company X, therefore, it has decided to update on the bid to take over the company as $25 per share resulting in increasing the price of company X’s shares to $25 per share but still this company is trading at its old price that is $20 per share. At this point consider that early investors who want to trade make the bid of $24 per share, you will notice that there is a difference of $1 per share at present. Now you will ask the question where is the risk in this? The risk is that the procurement might fall all the way down and in this case, the price of the shares of the company will go back to its previous price that is $20 per share.