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INSTRUMENTS
FINANCIAL ENGINEERING
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The most obvious form involves the purchase of the commodity in one
market and the simultaneous sale of the same commodity in a different
market. The commodity is purchased in the lower price market. The
arbitrager seeks to profit from the price discrepancy between the markets.
For
Forexample : : Commodity can be move between market 1 and market 2 at the
example
transportation cost of T1,2 and that is combined transaction cost involved in buying and
selling the commodity is R1,2. The spatial arbitrage is only profitable if the price of the
commodity in the higher price market is more than T1,2 + R1,2 greater than the price of the
commodity in the lower price market.
The prices of the same commodity in two different market never deviate
more than the cost of transportation and transaction. This thinking led to
the development of Law of one price
The law of one price states that the price in market I, denoted P i and the
price in the market j, denoted Pj are related as defined equation :
P i = Pj + Zi,j
Pi = Pj * Ei,j + Zi,j)
The law of one price can be expanded to allow commodities that are
different but are convertible into each other.
TEMPORAL ARBITRAGE
Another type of arbitrage that has long been practiced is temporal arbitrage
sometimes called carrying-charge arbitrage. It is applicable for storable
commodities.
In this form of arbitrage the market in which the commodity is brought and
the market in which it is sold differ temporally rather than spatially.
For example : an arbitrager observes that the commodity for immediate (spot) delivery can be
purchased for Pi(t,T). The difference between Fi(t,T) and Pi(t) should be equal to the cot of carry.
That is FI(t,T) and Pi(t) and should be related by below equation where Gi(t.T) denotes the cost of
carry which is defined as the interest cost plus the storage cost less any convenience yield.
TAX ARBITRAGE
There are two forms of arbitrage that are not captured in the above
equation. These are arbitrage across risk and tax arbitrage. Insurance is an
example of the former and preferred stock issued by low tax corporations
and held by high tax corporations is an example of the latter.
Recall the insurers take on many individually large risks and through the
pooling of these risk, dramatically reduce them. This is also kind of risk
abatement common in other forms of diversifications. That is through
proper structuring and diversification of portfolio, very risk individual
positions can be held with very little overall risk. If the parties bearing
individual risk are willing to pay a sufficiently large premium to be relieved
of them then the arbitrage can be profitable
For example : If we can duplicate the cash flow stream of instrument I by combining the
cash flow streams of instrument j and k that we have effectively replicated instrument i.
The combination of j and k that gives rise to the cash flows that mimic instrument I
constitute a synthetic instrument i.
SYNTHETIC PUTS
1. Synthetic puts
2. Synthetic zeros.
In the early 1970s the Chicago Board Options Exchange was created and
approved to trade a limited no. of listed call options on individual common
stock. At about the same time the CBOE was created, The exchange
argued that options would allow holders of equity positions to hedge those
positions. It is more true for put options. Thus, the holder of a long position
in a stock might like to hold a long position in a put option to hedge against
downside risk.
Academic theorists discovered using arbitrage theory that there is a
fundamental relationship between the value of a call option and the value of
the put option. This relationship became known as the put/call parity
theorem. It has two fundamental uses. First it can be used to value a put
option once the value of a call option is known and second it can be used
to formulate a synthetic put option.
P(t,T) denotes the current (time t) fair value of a put option that xpires at
time T , C(t,T) denotes the current fair value of a call option that expires at
time T,A(t) denotes the current price of the underlying asset, S is the strike
price of both the call and the put options, and B(t,T) is the current value of
$1 risk-free discount bond that matures at time T.
This easiest way to demonstrate the value equivalence is by pay off profiles
(sometimes call profit diagrams). Payoff profiles are usually drawn for the
option at the time of the option’s expiration.
Zero coupon bond is simply a bond that provides its holder with one and
only one cash flow. Such a bond trades at a discount from its face value
until such time as the bond matures.
In addition each zero has its properties that the conventional bond did not
possess. As proof of this, Consider duration. The duration of the
conventional bond is always shorter than its maturity. The duration of the
zero, on the other hand is identical to its maturity.
SYNTHESIZING DERIVATIVES
Many of the over the counter derivative instruments that have appeared in
recent years can be synthesized from other derivative instruments.
For example : Multi period options, such as caps and floors, can be synthesized from
a strip of single period put or single period call options. Similarly a short dated swap
(up to two or three years) can be synthesized from a strip of Euro dollor future
contracts.
For example : suppose that the 20.5 year treasury bond carries a coupon of 8.00 %
and I currently priced at 93 16/32 . At this price the instrument provides the yield to
maturity 8.684 % (bond equivalent of BEY). This instrument is deliverable against the
6 month forward T-Bond futures with a conversion factor of 1.000 That is $ 100,00
face value of this bond is deliverable per futures contract. At this point of delivery .
Bond itself will have maturity of 20 years. The future contract is priced at 93 2/32.
Solution: Investor will receive a coupon payment of $4 in six months. This represents
one half of the annual 8% coupon. Second the investor is going to sell the instrument
(deliver on the futures contract) for 93.0625. Thus in six months the investor will have
97.0625. Since the investor has the value at the end of 97.0625 at the current cost of
93.50. The investor return is 7.62 % . The calculation, which follows , is simple in this
case because the holding period I exactly one-half of a year.
As such position earns a short term rate , 7.62 % in this case and not the long term
rate 8.684% embodied in the bonds price.
CASH AND CARRY IN ARBITRAGE :
ENHANCING PORTFOLIO RETURN
As we know that if markets were always efficient , Synthetic T- Bills should
return the same rate as real T- Bills. Synthetic securities sometimes offer a
greater return and sometime offer lower return than real securities due to
imperfections in the market.
For example : Arbitrager can buy the 20.5 year T-bond and sell the T-bond futures to create a
synthetic T-bill thereby earning a certain return 7.62% . This rate is identical to the 7.62 % return
on real T-bills. It would appear that the arbitrager could invest equally profitable.
Under current market conditions arbitrager can purchase T- Bonds and then use them as
collateral in the repo market to obtain the funding used to purchase the bonds at a cost of
7.34%. Arbitrager can purchase T- bills and use them as collateral in the repo rate to obtain the
funding needed to purchase the bill at 7.42%
Under this scenario, The cash and carry (synthetic T-bills) is the superior investment for the
arbitrager since it returns 8bps more than T- bills
CREATING SYNTHETIC LONG BONDS
Cash and carry strategy can be use to create a synthetic short term
instrument, so we can also create synthetic long bonds.
Suppose that a pension fund has $1 million to invest in equity for 3 years. Rather than
invest in equity directly the pension funds decides to invest indirectly by synthesizing
equity from fixed rate note and an equity swap. The pension fund purchases a $1 million
face value three-year corporate note offering an annual coupon of 9% and currently priced
at par. At the same time. The pension fund enters into an equity swap with an equity swap
dealer. The swap calls for the pension fund to pay the swap dealer 8.5% annually I
exchange for the swap dealer paying the pension fund the return on the S&P 500. Both
payments will be calculated on the basis of $1 million notional principal. Importantly the
swap deal pays the pension fund when the equity return (S&P 500) is positive but the
pension funds pay the swap dealer when the equity return is negative.
8%
9%
Fixed rate note
Pension Fund Swap Dealer
Return on S&P