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.

BREAKING DOWN '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.

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RELATED FAQS
  1. How do I employ a cash-and-carry trade?

    The cash-and-carry trade is an arbitrage strategy of purchasing one security while simultaneously selling a similar security. ... Read Answer >>
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    Find out more about commodity spot and futures prices, how to calculate a commodity's futures price, and the differences ... Read Answer >>
  3. How do commodity spot prices indicate future price movements?

    Find out more about commodity spot and futures prices, how to calculate commodity futures prices and how spot prices indicate ... Read Answer >>
  4. What are some securities that have spot rates?

    Learn about the types of assets that have spot rates, and understand how the spot rate is used to determine the fair market ... Read Answer >>
  5. What are the biggest risks associated with covered interest arbitrage?

    Investing money can be confusing for novice investors. Find out more about covered interest arbitrage and the risks that ... Read Answer >>
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