Arbitrage is a process through which an investor can buy an asset or combination of assets at one price and concurrently sell at a higher price, thereby earning a profit without investing any money or being exposed to any risk.

In a well-functioning market, arbitrage opportunities should not exist. If they do exist, arbitrage activities would quickly eliminate the price differential. The no-arbitrage principle states that any rational price for a financial instrument must exclude arbitrage opportunities. This is the minimal requirement for a feasible or rational price for any financial instrument. There is no free money.

The role of arbitrage:

• It facilitates the determination of prices. The combined actions of many investors engaging in arbitrage result in rapid price adjustments that eliminate any arbitrage opportunities, thereby bringing prices back.

• It promotes market efficiency. Efficient markets are those in which it is impossible to earn abnormal returns, which are returns that are in excess of the return required for the risk assumed. Arbitrage activities will quickly eliminate arbitrage opportunities available in the market, thereby promoting market efficiency.

Hedgers vs. Speculators: two parties involved in the risk management process

Depending on their prior risk exposures, participants in the derivatives market can be classified into hedgers and speculators.

• A hedger trades futures to reduce some pre-existing risk exposure.
  • Prior to the transaction, the hedger does have risk exposure.
  • After the transaction, the hedger reduces risk exposure.
  • At the time of entering into hedging transactions, the hedger knows the benefit (reduced risk).
  • Hedgers are often producers or users of a given commodity.

• A speculator takes a view of the market, and accepts the market's risk in pursuit of profit.
  • Prior to the transaction, the speculator has no risk exposure.
  • After the transaction, the speculator has increased risk exposure.
  • The profits/losses of a speculative transaction are not known immediately.