Arbitrage-Free Valuation

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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