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Understanding Arbitrage

By Prof. Simply Simple

TM

Let me tell you a story about a Chaalu

Chaiwala!

He was truly chaalu or shall we say,

Extra Smart!!

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He would provide tea at Rs 5 per cupand his cost of preparing the same was

Rs 4.

Thus he made a profit of Rs 1.

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But he was not happy withmaking a profit of just Rs 1.

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So he thought about hecould increase his profit.

It was then that he had abrainwave out of the

blue!

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He identified a Governmentcanteen which offered tea at Rs 2.

BIG IDEA! Wasnt it?

He could now simply buy

tea for Rs 2 and sell it forRs 5 and make a much

better gain of Rs 3!

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This buying of a thing inone market and selling in

another market at a higherprice is known as

Arbitrage.

Similarly if arbitrageopportunities exist, stocks

too can be purchased in onemarket at a lower cost andsold in another at a higher

cost.

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But Alas! Such arbitrageopportunities do not last long. As

information flow increases and thearbitrage opportunity gets known, it

soon starts to disappear.

So for the next few days, our ChaaluChaiwala had a field day earning

happily as he served his daily chai.

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And this is exactly what happened inthe case of our chaiwala.

The chaiwala had an assistant whoone day spilled the beans about the

arbitrage advantage being enjoyedby the chaiwala.

Soon after that, the chaiwala wasrounded up and he confessed about

the arbitrage opportunity he hadspotted.

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Since his customers, in a sense, had

been paying a fair price all this whilesince Rs 5 had been the standard retailprice in all canteens, the chaiwala was

forgiven but was warned againstadopting this practice again.

So the arbitrage opportunity toovanished in thin air as the very

next day, he was back in his owncanteen making tea at Rs 4 and

selling it at Rs 5.

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Thus its important tounderstand that arbitrageopportunities are short-lived.

It is essentially a short window

of opportunity that can beexploited by taking action at theright time.

As information flow gets

efficient, this opportunityvanishes as we saw in the caseof the chaiwala.

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Hope this story succeeded in clarifying the concept

of Arbitrage

Please give me your feedback atprofessor@tataamc.com

mailto:professor@tataamc.commailto:professor@tataamc.com

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The views expressed in these lessons are for information purposes onlyand do not construe to be of any investment, legal or taxation

advice. The contents are topical in nature & held true at the time ofcreation of the lesson. They are not indicative of future market

trends, nor is Tata Asset Management Ltd. attempting to predict thesame. Reprinting any part of this presentation will be at your own

risk and Tata Asset Management Ltd. will not be liable for theconsequences of any such action.

Disclaimer