Arbitrage

8 Key excerpts on "Arbitrage"

• 

  eBook - ePub

  Encyclopedia of Financial Models

  • Frank J. Fabozzi(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Arbitrage is the simultaneous buying and selling of an asset at two different prices in two different markets. The Arbitrageur profits without risk by buying cheap in one market and simultaneously selling at the higher price in the other market. Such opportunities for Arbitrage are rare. In fact, a single Arbitrageur with unlimited ability to sell short could correct a mispricing condition by financing purchases in the underpriced market with proceeds from short sales in the overpriced market. This means that riskless Arbitrage opportunities are short-lived.

  Less obvious Arbitrage opportunities exist in situations where a package of assets can produce a payoff (return) identical to an asset that is priced differently. This Arbitrage relies on a fundamental principle of finance called the law of one price , which states that a given asset must have the same price regardless of the location where the asset is traded and the means by which one goes about creating that asset. The law of one price implies that if the payoff of an asset can be synthetically created by a package of assets, the price of the package and the price of the asset whose payoff it replicates must be equal.

  When a situation is discovered whereby the price of the package of assets differs from that of an asset with the same payoff, rational investors will trade these assets in such a way so as to restore price equilibrium. This market mechanism is founded on the fact that an Arbitrage transaction does not expose the investor to any adverse movement in the market price of the assets in the transaction.

  For example, consider how we can produce an Arbitrage opportunity involving three assets A, B, and C. These assets can be purchased today at the prices shown below, and can each produce only one of two payoffs (referred to as State 1 and State 2) a year from now:

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  Capturing Finance

  Arbitrage and Social Domination

  • Carolyn Hardin(Author)
  • 2021(Publication Date)
  • Duke University Press Books

    (Publisher)

  two Arbitrage in Theory The definition of Arbitrage proffered by financial economics affords it a central position within finance theory as the guarantor of market effi-ciency. In this role, Arbitrage actually fulfills a number of disciplinary and imaginary functions. For one, in financial economics, it actually appears most prominently in its absence, as the “no-Arbitrage condition,” which is used as a test that prices are efficient, that is, correct (Bodie et al. 2009, 325). But more broadly, market efficiency is a moral imperative within the neoliberal vision of the market as a better information pro cessor than any central planning agency could be (Hayek 1945). Since Arbitrage is the mechanism that ensures efficiency, it actually enacts a kind of wish fulfillment within the neoliberal imaginary. 1 It is thus unsurprising that, in addition to occupying a place of privilege in financial modeling, Arbitrage is also framed in broader popular and regulatory discourses as a benevolent force ensuring fair pricing for all market participants. In this chapter, I unpack Arbitrage’s paradoxical role in finance theory, its theoretical role in market efficiency and the broader neoliberal concep-tion of free markets, and the consequences of policymakers, regulators, and judges accepting the benevolent definition of Arbitrage proffered by financial economics. In short, I tell the story of the benevolent-efficiency narrative of Arbitrage to show that, through it, financial economics jus-tifies and protects the practice of Arbitrage from the kind of critical scrutiny it deserves. 34 Chapter two The Origins of Arbitrage in Financial Economics The term Arbitrage was probably not used until the eighteenth century, al-though the concept of buying and selling at differing prices is much older.

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  The Economics of Financial Markets

  • Roy E. Bailey(Author)
  • 2005(Publication Date)
  • Cambridge University Press

    (Publisher)

  Instead, the propositions make precise why Arbitrage plays such a key role in finance. 7.1 Arbitrage in theory and practice In much of financial analysis, ‘Arbitrage’ is interpreted loosely as the class of investment strategies designed to profit from perceived discrepancies among asset 166 Arbitrage 167 prices, while incurring low (but non-negligible) risks. 1 While this might be a reasonable description of some investors’ behaviour, a narrower definition serves to illuminate more clearly the implications of the absence of Arbitrage opportunities for asset prices. For this reason, throughout this book Arbitrage is confined strictly to investment strategies that entail zero risk. The payoff from any such strategy is then the risk-free rate of return on the initial capital outlay – or, more conveniently, a zero payoff from a zero initial outlay. The advantage of the narrow definition adopted here is that it focuses atten-tion on the Arbitrage principle as a generalization of the ‘Law of One Price’ (LoOP). If the same asset has two different prices, there is an immediate Arbitrage opportunity: sell at the higher price and buy at the lower. (See the example in chapter 1, page 16.) That such discrepancies cannot persist seems so natural as to be self-evident. There are pitfalls, however. Firstly, it may be difficult to determine whether or not an Arbitrage opportunity is present. The consequences of the absence of such opportunities are then equally difficult to determine. Secondly, suppose that unexploited Arbitrage opportunities are observed. That must be because one or more of the assumptions on which the Arbitrage principle rests is violated. The response is then either to refine the assumptions so as to restore the principle or, alternatively, to deny its usefulness. The former would, taken to its limit, render the principle a tautology and rob it of predictive significance.

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  International Financial Operations

  Arbitrage, Hedging, Speculation, Financing and Investment

  • I. Moosa(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  If the prices move rapidly, the value of assets an Arbitrager delivers and the value of assets delivered to him may differ, exposing him to additional risk of losses. So, is there after all a generic definition of Arbitrage? Although the term “Arbitrage” is used to describe a number of different operations, it may still be possible to come up with a generic definition. Such a definition would be based on two characteristics that are common to all of the operations described earlier. The first is that these operations aim at exploiting price anomalies in one or more markets. The second is that each operation is triggered by the violation of a pricing equilibrium condition. This condition is the equality of the exchange rates across financial centres in the case of two-point Arbitrage; the consistency of cross rates in the case of three-point Arbitrage; the equality of the forward spread and the interest rate differential (covered interest parity) in the case of covered interest Arbitrage; and the equality of the expected change in the exchange rate and the interest rate differential (uncov- ered interest parity) in the case of uncovered interest Arbitrage. In all cases, Arbitrage restores the equilibrium condition by changing the forces of supply and demand in the underlying markets. Hence a plausible generic definition of Arbitrage is the following. Arbitrage is a profit-seeking operation aimed at exploiting price anomalies arising from the violation of a pricing equilibrium condition. This definition says nothing about the absence of risk, the use of own capital or the simultaneity of buy and sell transactions. It is the closest thing to a valid generic definition of Arbitrage. 64 I N T E R N A T I O N A L F I N A N C I A L O P E R A T I O N S

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  Theory Of Valuation (2nd Edition)

  • Sudipto Bhattacharya, George Michael Constantinides(Authors)
  • 2005(Publication Date)
  • World Scientific

    (Publisher)

  Each section (except V) ends with a selective list of references to guide further reading. I. PURE Arbitrage PRICING THEORY An Arbitrage opportunity is the existence of a collection of assets that can be combined into a costless portfolio with some chance of a positive payoff and no chance of a negative payoff. There are two strong arguments for assuming that Arbitrage opportunities will not appear in security market price relationships. First, any investor who observes such an opportunity can make limitless profits (unless prices adjust). Second, all investors can improve on their current portfolios by reshuffling their holdings to take advantage of the Arbitrage opportunity. Chaos follows unless prices adjust. Notes on the Arbitrage Pricing Theory | 299 The absence of Arbitrage opportunities is a minimal condition for well-functioning capital markets. The standard tool for price analysis in free markets is the concept of competitive equilibrium. The absence of Arbitrage is a more general condition than the presence of competitive equilibrium, as codified below. KEY RESULT 1 . // the economy is in competitive equilibrium (and there exists at least one -nonsatiated investor) then there do not exist any Arbitrage opportunities. See Harrison and Kreps (1979, p. 385) for a proof. Arbitrage (more correctly nonArbitrage or the absence of Arbitrage) places linear restrictions on the relationships among asset prices. (In security market analysis we usually describe price in terms of expected return, which is essentially the reciprocal of price.) A complete characterization of these restrictions is provided in Key Result 2. For simplicity, assume that the economy lasts one period and there is a finite set of / possible outcomes, or states of the world, denoted by 0 l ,9 2 ,---,O l . Assume that there are N assets in the economy; asset i is represented by an l-vector R; giving the gross return of the asset for each possible state.

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  The Dialectics of Liquidity Crisis

  An interpretation of explanations of the financial crisis of 2007-08

  • Chris Jefferis(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  commensuration in forms and valuation techniques and hence the possibility of Arbitrage between previously segmented (national, sectoral, etc.) forms of capital. The real “efficiency” of markets is that more and more things are made commensurable, not that claims can be made about the Pareto optimality of prices.

  The process of market extension can make it look as if the adoption of new financial instruments and pricing techniques create an increase in value of the capital asset because of an increase in the integrity of valuation techniques, what is commonly called risk management or diversification; however, the source of value lies in their constructive dimension, in the historical transformation of the form of capital and growth of a new mode of evaluation through the extension of markets for risks.2 For instance, the development of securitisation in particular is a telling example of the story of the construction of Arbitrage opportunities. In this case, it occurred through the creation of a secondary market for the underlying capital assets, housing, which in itself could not be easily Arbitraged with other capital assets or traded in the financial system given the peculiarities of the mortgage contract (Wojnilower 1980:301–302, 1985:351–352). The creation of mortgage-backed securities (MBS) involved a process of abstraction whereby what came to be commodified was not so much the underlying asset, the house itself, as the mortgage borrower’s ability to pay the mortgage, that is, the yield on the asset (Bryan, Martin and Rafferty 2009).

  ABS were first developed by the American investment bank Salomon Brothers, which developed a way in the early 1980s to bundle mortgages together into a form of risk that resembled US government bonds. By bundling mortgages together in this way, Salomon Brothers ensured that the paper they created included a government guarantee and was structured in a form that facilitated its commensuration with other established assets, including Treasury bonds that enjoyed a large market as a relatively “safe” and liquid financial asset. The bankers at Salomon Brothers hoped to do this to help increase the amount of credit flowing into mortgage finance to take advantage of the difference in yield on mortgages above Treasury bonds while only taking on similar levels of risk (Lewis 1989, Ranieri 1996). This transformation marked the beginning of a significant increase in volume of investment in housing in the US economy that coincided with a dramatic increase in asset prices (Wojnilower 1985). This indicates how Arbitrage considered in terms of its historical dimensions as commensuration between forms of capital rather than in its idealised state as risk management can create liquidity and economic growth.

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  Arbitrage, Hedging, and Speculation

  The Foreign Exchange Market

  • Ephraim Clark, Dilip K. Ghosh(Authors)
  • 2004(Publication Date)
  • Praeger

    (Publisher)

  Chapter 5 Arbitrage and Hedging with Spot and Forward Contracts INTRODUCTION Arbitrage, as noted in chapter 1, is the exploitation of market misalign- ment, and hedging is the cover against any open risk-exposed positions of a participant in the marketplace. Academic research has taken us to two interesting ends on this issue of Arbitrage with hedging. At one end, we find that theoretical explorations of market potential have opened the eyes of actual traders and made them realize the fruits of the mechanics of financial markets. Asset markets in general—and currency market in par- ticular—have created conditions in which players make money without even taking any risk through Arbitrage, and on many occasions they gen- erate large amounts of profits by taking speculative positions—sometimes covered and sometimes naked. 1 On the other end of the spectrum, we note that it is the academic maxim mostly that intrigues others by letting them believe that markets are so well-aligned that Arbitrage opportunity can hardly exist in the real world, and hence risk-free profit-taking is a mere illusion. In this chapter, an attempt is made to examine how correct that analytical view is against the setting of real markets, how much academic research helps us understand the behavior of real traders, and to what extent the impression or belief that there is no scope for Arbitrage holds ground. We shall attempt to check into the foreign exchange market in which currencies are traded for spot and forward contracts almost 24 hours a day, where traders hardly get out of trading rooms. The plan of this chapter is as follows: In the following next five sections under the heading "Arbitrage Profits," we bring out the conditions for profitable Arbitrage with full hedging with and without transaction costs, and ascer- 132 Arbitrage, Hedging, and Speculation tain th+++++++++++++++++++++++++++++++++rofits) out of trading acts under admissible situations.

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  eBook - ePub

  The Strategic Analysis of Financial Markets

  (In 2 Volumes)Volume 1: FrameworkVolume 2: Trading System Analytics

  • Steven D Moffitt(Author)
  • 2017(Publication Date)
  • WSPC

    (Publisher)

  The idea of EMH.3 is that Arbitrageurs buy (sell) one portfolio followed by selling (buying) another that perfectly offsets it, while statistical Arbitrageurs buy one and sell another that offsets it only in expected value. Pure Arbitrage is usually possible for two or three instruments only. For example, a stock may trade briefly at different prices on two exchanges, or a forward contract may briefly move out of line with the cash market. But in reality, all Arbitrage is statistical Arbitrage, for all Arbitrage has some uncertainty; thus in common usage, the term “pure Arbitrage” refers to statistical Arbitrage that has a small chance of failing.

  It is convenient to use the market slang arbs to refer to Arbitrageurs, arbbing to refer to Arbitrage trading, and arbbing out to refer to the elimination of market mispricings by arbbing. Before launching a more thorough investigation of the EMH, it is useful to discuss some real market examples of Arbitrage in order to illustrate its limitations.

  Example 5.3.1 (Stock Index Futures Arbitrage). Stock index Arbitrage is the strategy of buying (selling) a portfolio of stocks that mimics a stock index, together with the selling (buying) of futures on that index. Stock index Arbitrage is based on the theoretical relationship between a stock index future and its underlying stock index. Recall that an expiration T future struck at price

  Ft

  at time t is just a contract that pays

  FT

  −

  Ft

  at time T > t — it is in effect a bet on the future price made at time t . Thus, any cash flows that might accrue to the underlying instrument after the establishment of the bet but before its expiration, are not paid to a futures holder. Using the notation

  the theoretical value3 of the future is

  All quantities on the right-hand side of (5.1) are known or can be estimated at time t , but as we discuss below, one cannot know all the uncertainties that are implicit in formula (5.1) . The first step in the Arbitrage is the identification of a portfolio of stocks that mimics the index — this portfolio is commonly called a basket of stocks or simply, a basket . If the future is too high relative to the index,

  arbs sell futures and buy baskets of roughly equal value. If the future is too low relative to the index,

  arbs buy futures and sell baskets of roughly equal value. At or before expiration, arbs unwind these positions by either (1) letting them expire and selling (buying) the stocks at expiration, or (2) near simultaneous selling (buying) of the futures and buying (selling) the basket prior to expiration, or (3) “rolling” the futures forward by trading a futures spread that moves the futures further out in the calendar. In the first two cases, a profit or loss is realized; in the third, the near-term future is realized and is replaced by another future. In effect, the position is shifted forward in time until it is eventually liquidated by methods (1) or (2). But in any case, a (usually small) net profit is secured. The main sources of risk in this Arbitrage are:

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