Arbitrageurs are the third important group of participants in futures, forward and options markets. Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets. Consider a stock that is traded on both the Exchange ABC and XYZ stock exchange.
Suppose that the stock price is $152 ABC exchange and $100 in XYZ exchange at a time when the exchange rate is $1.5500 per pound.
An arbitrageur could simultaneously buy 100 shares of the stock in ABC exchange and sell them in XYZ exchange to obtain a risk-free profit of 100*[($1.55*100)-$152] or $300 in the absence of transaction costs.
Transaction costs would probably eliminate the profit for a small investor. However, a large investment house faces very low transaction costs in both the stock market and the foreign exchange market.
It would find the arbitrage opportunity very attractive and would try to take as much advantage of it as possible.
Arbitrage opportunities such as the one just described cannot last long. As arbitrageurs buy the stock in ABC exchange. The forces of supply and demand will cause the dollar price to rise. Similarly, as they sell the stock in XYZ exchange, the sterling price will be driven down.
Very quickly the two prices will become equivalent at the current exchange rate. Indeed, the existence of profit-hungry arbitrageurs makes it unlikely that a major disparity between the sterling price and the dollar price could ever exist in the first place.
We can say that the very existence of arbitrageurs means that in practice only very small arbitrage opportunities observed in the prices that quoted in most financial markets.