What does "arbitrage" refer to in finance?

Arbitrage is a fundamental concept in finance that refers to the simultaneous purchase and sale of an asset in different markets to profit from price discrepancies. When a trader identifies that an asset is priced differently in two separate markets, they can buy the asset where it is undervalued and simultaneously sell it where it is overvalued, thus securing a profit without any risk due to the simultaneous nature of the transactions. This practice relies on the principle that prices tend to converge, and arbitrageurs help facilitate this by acting on the price differences, which can lead to more efficient markets.

In this context, describing arbitrage as the practice of increasing leverage to enhance returns, or as the assessment of market conditions for future investments, does not capture the essence of what arbitrage inherently involves. Similarly, identifying arbitrage with the risk of potential loss in investments misrepresents its nature, as arbitrage opportunities are typically explored to minimize risk rather than to amplify it. Understanding arbitrage is essential for grasping how financial markets operate and how traders can exploit price inefficiencies for profit.