Some Notes on Arbitrage

Arbitrage is a concept that comes up in finance and economics a lot. As I understand the concept, it requires that a market exist for at least three items (say, tomatoes, lettuce, and cucumbers). Suppose a head of lettuce costs two tomatoes, and one cucumber. In that case, we can assume that the cucumber is also worth two tomatoes. But what if it's actually 1.5 tomatoes? In that case, you want to exchange cucumbers for lettuce, then exchange the lettuce for tomatoes, and then "buy" cucumbers for all those tomatoes. If you start out with 1 cucumber, then you'll wind up with 1.333 cucumbers, then 1.777, then 2.370, then 3.161....without doing anything other than cart around a burgeoning pile of vegetables.

That's pretty much the whole concept. What makes it tricky is finding comparable items. Arbitrage opportunities involving things that belong to identical categories (like foreign exchange) will be rare.

Precious Metals Arbitrage

In the 19th-20th century, while currencies were officially pegged to gold, they often oscillated within a range of ±0.4-0.9% of the actual mint parity ratio (ratio of the two currencies respective gold content). These were known as the gold points: if the spot rate for a foreign currency exceeded the gold points, it was financially worthwhile to redeem the local currency in gold, and physically transport the currency abroad (or, conversely, import it from abroad). The problem was that the gold points had to be calculated by experts, and varied over time.

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