Not to be confused with Arbitration. The term is mainly applied to trading in financial instruments, such as bonds, forex arbitrage explained pdf, derivatives, commodities and currencies.
Arbitrage” is a French word and denotes a decision by an arbitrator or arbitration tribunal. If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium, or arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibrium. This refers to the method of valuing a coupon-bearing financial instrument by discounting its future cash flows by multiple discount rates. By doing so, a more accurate price can be obtained than if the price is calculated with a present-value pricing approach.
Arbitrage-free pricing is used for bond valuation and to detect arbitrage opportunities for investors. For the purpose of valuing the price of a bond, its cash flows can each be thought of as packets of incremental cash flows with a large packet upon maturity, being the principal. Since the cash flows are dispersed throughout future periods, they must be discounted back to the present. In the present-value approach, the cash flows are discounted with one discount rate to find the price of the bond.