CFA Level 1
Derivatives - Arbitrage
Arbitrage opportunities exist when the prices of similar assets are set at different levels. This opportunity allows an investor to achieve a profit with zero risk and limited funds by simply selling the asset in the overpriced market and simultaneously buying it in the cheaper market.
This buying and selling of the asset will push the cheaper asset's price up and the higher asset price down. This process will continue until the asset price is equal in both markets.
Achieving this equilibrium through buying and selling is referred to as the law of one price. This law may look like it has been violated at times, but this usually is usually not the case once you factor in financing or delivery costs associated with the different markets.
- For example, on exchange A IBN is trading at $25 and on exchange B IBN is trading at $30 dollars. If you buy IBN on exchange A and simultaneously sell it on exchange B, you can net a profit of $5 with out any risk or any outlay of cash.
- As people continue to buy on exchange A, the price of IBN will increase and all of the selling of IBN on exchange B will force the price down until equilibrium has been reached. This is how arbitrage works to make the marketplace efficient.
Additional information about arbitrage and its theories:
- Theoretically, the large number of market participants combined with real-time price-setting mechanisms eliminates the opportunity to generate risk-free profits.
- This leads to an important question: If there are no arbitrage opportunities (i.e. opportunities to earn a risk-free profit), why does the industry survive? One reason is that individual investors may have different views on how, why and to what degree market prices are off kilter. Also, investors are reluctant to believe that there are no arbitrage opportunities and so they spend a good deal of time watching price movements, ferreting out inconsistencies and trading on those they perceive to exist. The process itself ensures that any potential arbitrage opportunities will be quickly discovered and eliminated. If investors believed there were no arbitrage opportunities and were no longer vigilant about identifying and exploiting price differentials, the lack of continuous oversight might, in itself, lead to arbitrage opportunities In other words, disbelief concerning the absence of arbitrage opportunities is required to maintain its legitimacy as a principle.
- Relatively efficient markets have either no arbitrage opportunities or the market participants quickly remove them. The opportunity can occur, but only through chance and it would be considered an abnormal return
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