What Is Arbitrage-Free Valuation?
Arbitrage-free valuation is valuing an asset without taking into consideration derivative or alternative market pricing. Arbitrage is when you buy and sell the same security, commodity, currency, or any other asset in different markets or via derivatives to take advantage of the price difference of those assets. For example, purchasing a stock on the NYSE and selling it on the LSE in the U.K. for a higher price is arbitrage.
- Exploiting price differences in different markets is known as arbitrage—it is a hallmark of business and stock trading.
- Arbitrage-free valuation is valuing an asset without taking into consideration derivative or alternative market pricing.
- Exchanges and trading platforms often do not allow for risk-free arbitrage trades and information technology has eliminated a lot of arbitrage profits.
- Arbitrage can be used on derivatives, stocks, commodities, convenience costs, and many other types of liquid assets.
How Arbitrage-Free Valuation Works
Arbitrage can severely inflate or deflate the true price of the asset. The firm is doing the same work and has the same underlying capital structure, asset mix, cash flow, and every other metric regardless of what exchange it is listed on or derivative pricing. Arbitrage-free valuation is when price discrepancies are removed, allowing for a more accurate picture of the firm’s valuation based on actual performance metrics.
Arbitrage-free valuation is used in a couple of different ways. First, it can be the theoretical future price of a security or commodity based on the relationship between spot prices, interest rates carrying costs, exchange rates, transportation costs, convenience yields, etc. Carrying costs are simply the cost of holding inventory.
It can also be 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. Convenience yield is when you hold on to the actual physical good versus the liquid asset. An example would be holding on to a barrel of oil versus holding on to an oil futures contract. When the actual futures price does not equal the theoretical futures price, arbitrage profits may be made.
Arbitrage is more useful for traders rather than investors.
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. A cash-and-carry trade exploits the price difference between an underlying asset and its derivative. 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, hence why there is often times such a large difference in the bid-ask spread. Put another way, the house always wins.
Arbitrage-Free Valuation Example
While long-term Warren Buffett style investors may not be interested in companies that are heavily arbitraged, traders can utilize arbitrage as a way to make money. If you think about it, it’s one of the oldest tricks in the book. Oranges used to sell for a premium in New York City because they could only be grown in Florida, and additional places where weather permitted it.
Savvy businessmen would take advantage of this and utilize the arbitrage to make money. In that same spirit, traders can do the same thing. You can take advantage of exchange rates, futures, and various other forms of investments. There is no shortage of ways to make money. Let’s talk about a few and how arbitrage is utilized.