Arbitrage, as defined in macroeconomics, is the process of buying low and selling high in such a way as to add no intrinsic value, but rather profit over an unstable balance of supply and demand.

For example, if one plots a graph of interest rates of loans against the term of the loan, one finds that, if expectations are constant, long-term loans offer only slightly higher interest rates despite involving a longer commitment. The reason is arbitrage: if long-term loans offered significantly higher interest rates, people would string several shorter-term loans together and then lend the borrowed money out again for the higher, long-term loan interest rate, thereby profiting from the initial, unstable state of the market. When enough people attempt to do just that, the demand for short-term loans rises and so too does the interest rate until arbitrage is no longer profitable. Of course, the arbiter takes a significant risk upon himself: should the second or third of a string of short-term loans be refused, he's in a lot of hot water. Hence, long-term interest rates do remain slightly higher, because the process of arbitrage finds the equilibrium between profitability and unacceptable risk.

Essentially, arbitrage is the equalizing force in the market that inevitably pulls things back to equilibrium.

Ar"bi*trage (#), n. [F., fr. arbiter to give judgment, L. arbitrari.]

1.

Judgment by an arbiter; authoritative determination.

[Archaic]

2. Com

A traffic in bills of exchange (see Arbitration of Exchange); also, a traffic in stocks which bear differing values at the same time in different markets.

 

© Webster 1913.

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