Reading 67: Derivative Markets and Instruments LOSe习题精

An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless rate to purchase the position will produce a certain future amount greater than the amount required to repay the loan.

If two securities have identical payoffs regardless of events, the process of arbitrage will move prices toward equality. Arbitrageurs will buy the lower priced position and sell the higher priced position, for an immediate profit without any future liability. The law of one price (for securities with identical payoffs) is not a process; it is ‘enforced’ by arbitrage.

An arbitrage opportunity is the chance to make a riskless profit with no investment.  In essence, finding an arbitrage opportunity is like finding free money.  As you recall, in arbitrage, you observe two identical assets with different prices.  Your immediate response should be to buy the cheaper one and sell the expensive one short.  You can then deliver the cheap one to cover your short position.  Once you take the initial arbitrage position, your arbitrage profit is locked in.  The no-investment statement referenced in the text refers to the assumption that when you short the expensive asset, you will be given access to the cash created by the short sale.  With this cash, you now have the money to buy the cheaper asset.  The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves.

Since any observed pricing errors will be instantaneously corrected by the first person to observe them, any quoted price must be free of all known errors.  This is the basis behind the text’s no-arbitrage principle, which states that any rational price for a financial instrument must exclude arbitrage opportunities.  The no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial markets.  This means that markets and prices are efficient.  That is, all relevant information is impounded in the asset’s price.  With arbitrage and efficient markets, you can create the option and futures pricing models presented in the text.

In order to be considered arbitrage there must be no risk in the trade.

It doesn’t matter if commissions are paid as long as the amount of the price discrepancy is enough to offset the amount paid in commissions.

In order to be considered arbitrage there must be no initial investment of one’s own capital. One must finance any cash outlay through borrowing.

Arbitrage is the opportunity to trade in identical assets that are momentarily selling for different prices. Arbitrageurs act quickly to make a riskless profit, causing the price discrepancy to be instantaneously corrected. No capital is required, because opposite trades are made simultaneously.

Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer to the cost of trading. One necessary criterion for market efficiency is rapid adjustment of market values to new information. Arbitrage, trading on a price difference between identical assets, causes changes in demand for and supply of the assets that tends to eliminate the pricing difference.