arbitrage

From ancient to modern

Arbitrage and efficient markets

 No investment and no risk

 Profitable investment opportunities exist.
 This is called pure arbitrage
 In efficient markets no possibilities of any
arbitrage.
Arbitrage -In reality
 Exploit price discrepancies with little risk and
at least modest investment.
 The simultaneous purchase and sale of an
asset in order to profit from a difference in
the price. This usually takes place on
different exchanges or marketplaces.
Arbitrage and speculation

 Speculation- Exploits changes in prices

 Arbitrage – difference in valuations in
different markets.
Here's an example of arbitrage:

 a "riskless profit".
  Say a domestic stock also trades on a foreign
exchange in another country, where it hasn't
adjusted for the constantly changing exchange
rate.
 A trader purchases the stock where it is
undervalued and short sells the stock where it is
overvalued, thus profiting from the difference.
 recommended for experienced investors only.
Types of arbitrage
More conventional
Spatial/ Geographic
Temporal
Over instrument

Most recent
Arbitrage over risk
Tax arbitrage

1.
Spatial arbitrage
 Purchasing and selling the same security at the
same time in different markets to take advantage
of a price difference between the two separate
markets.
 An arbitrageur would short sell the higher priced
stock and buy the lower priced one. The profit is
the spread between the two assets.
When profitable

P2-p1> T12+ R12

Where T12 = Transportation cost

R12= transaction cost

The law of one price

 If there are no barriers to trade,

 prices between two markets cannot deviate
by more than T12+ R12
Spatial arbitrage in currencies

 The exchange rate shall become relevant

Pi= pj * Eij+ zij

If the commodities are not same

 Then conversion cost

 Raw silver to coins
 Gold 95 to 99 %
 Zij= Tij+ Rij + Cij
Temporal/ carrying charge arbitrage

 Storage commodities
 Spot-future parity (or spot-futures parity) is a parity condition
that should theoretically hold, or opportunities for arbitrage exist.
Spot-future parity is an application of the law of one price.
 In plain English, if I can purchase a good today for price S and
conclude a contract to sell it one month from today for price F,
the difference in price should be no greater than the cost of using
money minus any expenses (or earnings) from holding the asset;
if the difference is greater, I would have an opportunity to buy
and sell the "spots" and "futures" for a risk-free profit.
 The parity condition is that if an asset can be
purchased today and held until the exercise
of a futures contract, the value of the future
should equal the current spot price adjusted
for the cost of money, dividends,
"convenience yield" and any carrying costs
(such as storage).
Arbitrage over instruments

 Called conversion arbitrage

 Creation of zero coupon bond from conventional
bond
 Amount and size of cash flow
 Risk and tax advantage
 ½ year Zero

1year Zero
N year Decompose cash
1.5 year Zero
conventional bond inflow

2 year Zero

N year Zero
Arbitrage Over risk

 Reinsurance industry
 High risk individual assets are changes with
low risk individual assets
 Insurance companies
Tax arbitrage
details

 Interest rate of 182 days T-bills 8.20% p.a. in

America
 Interest rate of 182 days T-bills is 9.30% p.a.
in Germany
 Spot exchange rate= 1 $= 1.9550 DEM
 Money borrowed in American money market
$1,00,000.
If invested in America

 Monet at the end of 182 days would have

been 100,000+ 4145.56= 104145.56 dollars
 In Germany DEM 195500 was invested for
182 days and money at the end is
 195500 DEM+ Interest for 182 days @ 9.30%
 = 204691.75 DEM
 204691.75 DEM converted into $ after 182
days shall yield

 204691.75/1.9550 = 104701.67
 Profit from covered interest arbitrage is
104701.67- 104145.56
 Investment in Germany better than
investment in America
assignment

 If DEM/$ exchange rate in spot market

declines to 1.9495 and in forward market
increases to 1.9599 find out the arbitrage
profit.
References

 Page 208-209
 Page 429-430
 Page 219-236
 Page 573-578

 financial engineering by Marshall and

Bansal