Arbitrage

The textbook form takes three shapes. Triangular arbitrage exploits a directly quoted rate between two currencies disagreeing with the rate implied by routing through a third. Basis arbitrage holds a cash instrument against the future written on it, capturing the difference between the two as they converge toward expiry. Fund arbitrage keeps a listed fund near the value of the assets it holds.

That last mechanism is worth stating exactly, because it is the reason a listed fund tracks anything at all. Certain institutions, known as authorised participants, are permitted to exchange a basket of the underlying securities for newly created fund shares, and to reverse the exchange. When the fund's traded price rises above the value of its holdings they create shares and sell them, and when it falls below they buy shares and redeem them. The trade is profitable to them and the effect on everyone else is that the traded price stays close to the value of what the fund owns.

Described as riskless, arbitrage is riskless only in a textbook where both legs execute at the quoted prices simultaneously and funding is free. In a market one leg fills and the other moves, financing the position costs something for as long as convergence takes, and the differences that survive are usually the ones that are expensive to reach. Retail attempts to arbitrage one provider's quotation against a faster feed are a recognised phenomenon, and providers address them in their client terms rather than in the market, which makes them a contractual question rather than a trading one.