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Arbitrage 1 Spatial Arbitrage

Case Brief Arbitrage 1 Spatial Arbitrage Case Brief


Introduction This case introduces traders to trading motivated by arbitrage. We begin with a simple spatial arbitrage case. Traders are given the opportunity to trade the same security in two different markets. Each market uses a different currency, but the foreign exchange rate is fixed and known. Therefore, there is no uncertainty in this case which results in a pure arbitrage example.

Tradable Securities, Endowments and Interest Rates The ARB1 case has 1 tradable security on two different markets. The common equity of Applied Machine Corp (AMC) is tradable on the Local Stock Exchange or the Foreign Stock Exchange. The fixed exchange rate is 1.10 units of Local Currency (CAD) per unit of Foreign Currency (USD). All brokerage commissions are charged in the currency of the market. Ticker AMC-LSE AMC-FSE Currency CAD USD Starting Price 3.30 CAD 3.00 USD

Traders begin the case with an endowment of $1,000,000 dollars and can buy-long and short-sell the stock on either market. Any trades will settle immediately, be converted to CAD if transacted on the FSE, and then debited or credited to the local currency (CAD) account. Traders will trade for 1 period which lasts 5 minutes. This period represents 1 day of calendar time. The risk free rate is set to 0% per annum. Starting Endowment Trading Periods Period Time Calendar Time per Period Risk-Free Rate $1,000,000 1 300 seconds (5 minutes) 1 day 0%

Margin Requirements and Trading Costs A trading fee of 2 cents per share is charged for every transaction on either market. This commission is charged in the currency of the market. Shares are marginable. A margin loan of 50% of a stocks value is given for long positions, and margin collateral of 150% of a stocks value is required for short positions. There is a maximum order size of 10,000 shares when submitting a single order.

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Arbitrage 1 Spatial Arbitrage

Case Brief
Liquidity Traders Liquidity traders marked as ANON in the order book are active in both markets and continuously submit market and limit orders to cause price fluctuations in both stocks. Liquidity trades have randomly generated prices, normally distributed around the mid-market price. The order is determined to be a buy or sell order based on comparing the mid-market price with a stochastically generated stock path. ANON traders will attempt to drive the market price towards the pre-generated path price.

Position Close Out All positions of AMC in the local market will be closed out at the last price that traded on the local market. Long positions will be sold at that price and short positions will be bought back at that price. All positions of AMC in the foreign market will be closed out on the local market as well.

Sample Trades: Buy 100 AMC-LSE @ 3.40 CAD Sell 100 AMC-FSE @ 3.20 USD Final AMC-LSE price: 3.35 CAD Close out 100 AMC-LSE @ 3.35 CAD Close out 100 AMC-FSE @ 3.35 CAD

(3.35 CAD 3.40 CAD) * 100 Shares 2.00 = - 7.00 CAD 3.20 USD 1.10 CAD/USD = 3.52 CAD (3.52 CAD - 3.35 CAD) * 100 Shares 2.20 = 14.80 CAD Profit = -7.00 + 14.80 = 7.80 CAD

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