Arbitrage

The exploitation of security mispricing in such a way that risk-free economic profits may be earned is call arbitrage.  

The exploitation of security mispricing in such a way that risk-free economic profits may be earned is call Arbitrage. It involves the simultaneous purchase and sale of equivalent securities in order to profit from discrepancies in their price relationship, and so it is an extension of the law of one price.

An arbitrage opportunity arises when an investor can construct a zero investment portfolio that will yield a sure profit. The emphasis is on sure, that means is risk-free. A zero investment portfolio means that the investor need not use any of his or her own money. Obviously, to be able to construct a zero investment portfolio one has to be able to sell short at least one asset and use the proceeds to purchase (go long on) one or more assets. Borrowing may be considered a short position in the risk-free asset. Even a small investor using short position in this fashion can take a large dollar position in such a portfolio.

An obvious case of an arbitrage opportunity arises when the law of one price is violated. When an asset is trading at different prices in two markets (and the price differential exceeds transaction costs), a simultaneous trade in the two markets can produce a sure profit (the net price differential) without any investment. One simply sells short the asset in the high-priced market and buys it in the low-priced market. The net proceeds are positive, and there is no risk because the long and short positions offset each other.