Arbitrage-Free Valuation

AAA

DEFINITION of 'Arbitrage-Free Valuation'

1. The theoretical future price of a security or commodity based on the relationship between spot prices, interest rates, carrying costs, convenience yields, exchange rates, transportation costs, etc.

2. The theoretical spot price of a security or commodity based on the futures price interest rates, carrying costs, convenience yields, exchange rates, transportation costs, etc.

When the actual futures price does not equal the theoretical futures price, arbitrage profits may be made.

INVESTOPEDIA EXPLAINS 'Arbitrage-Free Valuation'

Cash-and-carry trades, reverse cash-and-carry trades, and dollar roll trades are all examples of trades made by arbitrage traders when theoretical and actual prices get out of line. Of course, setting up and executing such trades is complex. For the trade to be truly risk free, variables must be known with certainty and transaction costs must be accounted for. Most markets are too efficient to allow risk-free arbitrage trades.

RELATED TERMS
  1. Cash-And-Carry Trade

    A trading strategy in which an investor buys a long position ...
  2. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  3. Spot Price

    The current price at which a particular security can be bought ...
  4. Futures Contract

    A contractual agreement, generally made on the trading floor ...
  5. Cape Cod Method

    A method used to calculate loss reserves that uses weights proportional ...
  6. Kenney Rule

    A ratio of an insurance company’s unearned premiums to its policyholders’ ...
RELATED FAQS
  1. What is arbitrage?

    Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. ... Read Full Answer >>
  2. How does a company decide when it is going to split its stock?

    There are no set guidelines or requirements that determine when a company will split its stock. Often, companies that see ... Read Full Answer >>
  3. What are the benefits of using ceteris paribus assumptions in economics?

    Most, though not all, economists rely on ceteris paribus conditions to build and test economic models. The reason they do ... Read Full Answer >>
  4. How is fair value calculated in the futures market?

    The fair value is the theoretical calculation of how a futures stock index contract should be valued considering the current ... Read Full Answer >>
  5. What is the difference between the rule of 70 and the rule of 72?

    The rule of 70 and the rule of 72 give rough estimates of the number of years it would take for a certain variable to double. ... Read Full Answer >>
  6. What are the major types of insurance policies that insurance companies will offer?

    The principal commodities used in producing chemicals are oil, natural gas, coal and a wide variety of metals and minerals. ... Read Full Answer >>
Related Articles
  1. Options & Futures

    Contango Vs. Normal Backwardation

    Learn about the futures curve and what its shape means for hedgers and speculators.
  2. Options & Futures

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  3. Insurance

    Futures Fundamentals

    For those who are new to futures but want a solid understanding of them, this tutorial explains what futures contracts are, how they work and why investors use them.
  4. Fundamental Analysis

    Calculating the Herfindahl-Hirschman Index (HHI)

    The Herfindhal-Hirschman Index, (HHI) is a measure of market concentration and competition among market participants.
  5. Investing Basics

    Understanding Non-Deliverable Forward (NDF)

    A foreign exchange hedging strategy where the parties agree to settle the profit or loss in a foreign currency futures contract before the expiration date.
  6. Investing

    How To Implement A Smart Beta Investing Strategy

    Smart beta investing is the notion of re-writing investment rules to improve investment outcomes by targeting exposures to intuitive ideas or factors.
  7. Options & Futures

    How & Why Interest Rates Affect Options

    The Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.
  8. Investing Basics

    Explaining Currency Swaps

    A swap that involves the exchange of principal and interest in one currency for the same in another currency.
  9. Investing

    Market Crisis: Does Diversification Still Work?

    If you still aren’t sold on the benefits of international diversification, you may object that: Diversification didn’t work during the last market crisis.
  10. Investing

    The Risks & Rewards of Penny Stocks

    Penny stocks can make you a lot of money in a short period of time, but this is a very dangerous game that almost always will leads to losses.

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  3. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as ...
  5. Rule Of 70

    A way to estimate the number of years it takes for a certain variable to double. The rule of 70 states that in order to estimate ...
  6. Risk Premium

    The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is ...
Trading Center