DISCLAIMER: The explanations and analogies made here are oversimplified to a large extent. This article only gives you some material to easily understand complex financial concepts and initiate a discussion on them.

Hi there, readers! Here’s the second article on Phynance!

This one’s on arbitrage. I will present the concept of arbitrage and its implications in a physics form and explain things deeply iteratively. Dive right in and see what physics tells us about arbitrage.

Let me begin by explaining what ‘Arbitrage’ is

Arbitrage is basically the process of exploiting the price differences of an asset in different markets to generate risk-free returns.

The thing about arbitrage is that these opportunities vanish just as fast as they appear! Because acting upon these opportunities when they present themselves essentially eliminates them. So, a trader has to be (very) quick to pick up on these and trade in both the sell side and the buy side with very minimal time delay.

Now, how is Physics relevant here?

Well, a lot of physics is very relevant here.

But, we will limit our discussion to the “First Law of Thermodynamics” (Abbreviated as ‘FLOT’).

FLOT states that

“In a closed system, energy is neither created nor destroyed. It only transfers from one form to another.”

This simple law largely governs everuything in physics from particle interactions to the expansion of the universe!

FLOT works with the definition of Arbitrage thanks to its self-correcting nature. While the chaotic world of financial markets isn't exactly a perfectly closed system, this principle of conservation provides us with a powerful lens.