Many find it difficult to understand but its quite not.lets get started In pure arbitrage, you invest no money, take no risk and walk away with sure profits. It can be said in 3 ways
1.Pure arbitrage, where, in fact, you risk nothing and earn more than the riskless rate( normally the 10yr bond rate )
2. Near arbitrage, where you have assets that have identical or almost identical cash flows, trading at different prices, but there is no guarantee that the prices will converge and there exist significant constraints on the investors forcing convergence.
3.Speculative arbitrage, which may not really be arbitrage in the first place.Here, investors take advantage of what they see as mispriced and similar (though not identical) assets, buying the cheaper one and selling the more expensive one.
Well in Pure arbitrage, you have two assets with identical cashflows and different market prices makes pure arbitrage difficult to find in financial markets.
There are two reasons why pure arbitrage will be rare:
• Identical assets are not common in the real world, especially if you are an
equity investor.
• Assuming two identical assets exist, you have to wonder why financial markets would allow pricing differences to persist.
• If in addition, we add the constraint that there is a point in time where the market prices converge, it is not surprising that pure arbitrage is most likely to occur with derivative assets – options and futures and in fixed
income markets, especially with default-free government bonds.
FUTURE
A futures contract is a contract to buy (and sell) a specified asset at a fixed
price in a future time period. The basic arbitrage relationship can be derived fairly easily for futures
contracts on any asset, by estimating the cashflows on two strategies that deliver the same end result – the ownership of the asset at a fixed price in the future.
• In the first strategy, you buy the futures contract, wait until the end of the contract
period and buy the underlying asset at the futures price.
• In the second strategy, you borrow the money and buy the underlying asset today
and store it for the period of the futures contract.
• In both strategies, you end up with the asset at the end of the period and are
exposed to no price risk during the period – in the first, because you have locked in
the futures price and in the second because you bought the asset at the start of the
period. Consequently, you should expect the cost of setting up the two strategies to
exactly the same.
tough it would be better if it can be explained through a example.
1.Pure arbitrage, where, in fact, you risk nothing and earn more than the riskless rate( normally the 10yr bond rate )
2. Near arbitrage, where you have assets that have identical or almost identical cash flows, trading at different prices, but there is no guarantee that the prices will converge and there exist significant constraints on the investors forcing convergence.
3.Speculative arbitrage, which may not really be arbitrage in the first place.Here, investors take advantage of what they see as mispriced and similar (though not identical) assets, buying the cheaper one and selling the more expensive one.
Well in Pure arbitrage, you have two assets with identical cashflows and different market prices makes pure arbitrage difficult to find in financial markets.
There are two reasons why pure arbitrage will be rare:
• Identical assets are not common in the real world, especially if you are an
equity investor.
• Assuming two identical assets exist, you have to wonder why financial markets would allow pricing differences to persist.
• If in addition, we add the constraint that there is a point in time where the market prices converge, it is not surprising that pure arbitrage is most likely to occur with derivative assets – options and futures and in fixed
income markets, especially with default-free government bonds.
FUTURE
A futures contract is a contract to buy (and sell) a specified asset at a fixed
price in a future time period. The basic arbitrage relationship can be derived fairly easily for futures
contracts on any asset, by estimating the cashflows on two strategies that deliver the same end result – the ownership of the asset at a fixed price in the future.
• In the first strategy, you buy the futures contract, wait until the end of the contract
period and buy the underlying asset at the futures price.
• In the second strategy, you borrow the money and buy the underlying asset today
and store it for the period of the futures contract.
• In both strategies, you end up with the asset at the end of the period and are
exposed to no price risk during the period – in the first, because you have locked in
the futures price and in the second because you bought the asset at the start of the
period. Consequently, you should expect the cost of setting up the two strategies to
exactly the same.
tough it would be better if it can be explained through a example.
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