In financial markets, what does arbitrage refer to?

Arbitrage refers to the practice of exploiting price differences in different markets or forms of an asset to make a profit without taking on risk. In essence, an arbitrageur buys an asset in one market where the price is low and simultaneously sells it in a different market where the price is high. This process takes advantage of the inefficiencies in the market where prices do not align perfectly.

By definition, arbitrage opportunities arise when there is a mispricing of an asset, allowing traders to capitalize on discrepancies before the market corrects itself. This principle is fundamental to financial economics, as it contributes to the overall efficiency of markets. When arbitrageurs act on these price differentials, their trading helps to bring prices back into equilibrium, thus enhancing market efficiency.

In contrast, the other options describe different financial practices. Buying assets on credit involves taking on debt to purchase assets, which does not inherently involve exploiting price differences. Diversifying investments is aimed at reducing risk through a variety of asset holdings, lacking the element of taking advantage of price inefficiencies. Hedging against risk is a strategy used to offset potential losses in investments, but again, it does not involve the exploitation of price discrepancies in the same way arbitrage does.