Arbitrage

Definition

Arbitrage is the practice of taking advantage of price differences in different markets for the same asset, allowing traders to make a profit without risk. This concept is crucial in financial markets as it helps to ensure that prices reflect the true value of assets. By exploiting price discrepancies, arbitrage plays a significant role in maintaining market efficiency and liquidity across various financial instruments.

5 Must Know Facts For Your Next Test

1. Arbitrage opportunities arise when there is a discrepancy between the prices of the same asset in different markets, enabling traders to buy low in one market and sell high in another.
2. The process of arbitrage helps to eliminate price differences quickly, as more traders identify and act on these opportunities, leading to price adjustments.
3. In the context of futures and forward contracts, arbitrage can be used to lock in profit by simultaneously buying and selling contracts at different prices.
4. Binomial option pricing models can also include arbitrage opportunities, as they help determine fair option prices by considering different paths an asset's price can take.
5. Arbitrage pricing theory (APT) provides a framework for understanding how various factors influence asset prices and allows investors to identify potential arbitrage opportunities based on those factors.

Review Questions

• How does arbitrage contribute to market efficiency and what role do different types of contracts play in this process?
  • Arbitrage enhances market efficiency by correcting price discrepancies that exist across different markets or instruments. When traders identify these discrepancies, they execute buy and sell orders simultaneously, which brings prices into alignment. In the context of contracts like forwards and futures, traders can lock in profits through arbitrage by capitalizing on differing prices between contract agreements and spot prices, thereby ensuring that markets reflect the true value of assets.
• Discuss how the concept of arbitrage applies within the binomial option pricing model and its importance for options trading.
  • Within the binomial option pricing model, arbitrage opportunities emerge when calculated option prices deviate from market prices. This model lays out multiple possible future prices for an underlying asset, and if the market price of an option doesn't align with its expected value based on these future paths, traders can exploit this mispricing through arbitrage. This process is essential for maintaining fair pricing in options trading, as it encourages traders to act swiftly to correct any inconsistencies.
• Evaluate the significance of arbitrage pricing theory (APT) in understanding asset pricing and its implications for investors seeking arbitrage opportunities.
  • Arbitrage pricing theory (APT) holds substantial significance as it introduces a multifactor approach to asset pricing, suggesting that various economic factors influence returns. By analyzing these factors, investors can identify mispriced assets relative to their expected returns based on APT. This ability allows savvy investors to engage in arbitrage strategies effectively, potentially leading to profits while contributing to overall market efficiency. The implications extend beyond simple trades; they guide long-term investment strategies by helping investors assess risk and value across different asset classes.

Related terms

Hedging: A risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset.

Market Efficiency: A condition in which asset prices fully reflect all available information, making it impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis.

Risk-Free Rate: The theoretical rate of return on an investment with zero risk, often represented by government bonds.