arbitrage Flashcards
theoretical arbitrage
trading strategy that requires no initial investment, has no negative cashflow at any time, has positive cashflow at at least one time
when is arbritrage possible
when there is mispricing and arbitrage forces prices to converge, buy low sell high, rewuires long and short positions
dominance argument
numerous small investors marginally adjust their holdings depending on their degree of risk aversion
arbitrage argument
a few large investors try to take as big a position as possible and the degree of risk aversion doesn’t matter
practical arbitrage
trading strategy that is expected to make profit in expectation, each arbitrageur wants to invest an infinite amount of money in the strategy, care is needed with longer term strategies
true arbitrage
doesn’t/cannot exist, if existed, people would take advantage and prices would adjust to take advantage of them. the no-arbitrage condition is a cornerstone of asset pricing
ARBITRAGE OPPORTUNITIES
Rare, ephemeral, subtle, complex, risk of interim adverse price movements, eroded by frictions
bid-ask spread
mid = bid + ask/2 = used to value holdings, is the transaction cost investors must pay in order to trade
determining bid - ask spread
depends on liquidity
want sufficient number of buyers and sellers of a security - ensures trading at any time at the current market price
illiquid markerts
market prices are no longer a measure of value leading to loss of information
market makers care about..
liquidity risk, wider spread required to handle low trading volume assets
volatility risk - wider safety net needed (wider spread0
internal guidelines on inventory
reputation
adverse selection - risk of an informed counterpart (why is the person getting rid of a product_
market order
executed immediately at current marketprice complication - what if order is larger than maximum size for the price, pro - quick, con - may get worse price
limit order
trade at best price available pro - get good price con may not execute
stop order
triggered when price reaches a specific limit price pro: limit losses in trader’s absence, con could be worst time to trade
fill or kill
expires immediately following submission, no partial trading
implications of no arbitrage - LOOP
law of one price - if two securities have same payoff, have same price
implications of no arbitrage - portfolio replication
if a portfolio has the same payoff as a security it must have the same price
dynamic hedging strategy
if self-financing strategy has the same payoff as a security it must have the same price.
frictions
transaction costs - hence in the presence of trans costs there cannot be deterministic price
no arbitrage price range
NPV (net PV) of trading securities
trading security as investment decision, if a normal (no arbitrage) market then no-arb price of a security = PV
NPV (buying) = PV - price = 0
NPV (selling) = price - PV = 0
zero-sum trading game
if in a competitive market NPV <0 or NPV >0, one counterparty benefits, one loses, there may be no trade. FINANCIAL TRANSACTIONS SHOULD NOT BE SOURCES OF VALUE but should serve to adjust the timing and risks of the cashflows to suit the needs of firms and investors.
FX arbitrage
the strategy of exploiting price disparity in the forex markets
Equities arbitrage
Practice of buying and selling shares of a particular stock to exploit tiny differences in their prices across different markets.
adverse selection
problem arising under asymmetric information - when one counterparty has more information than the other the other is right to be worried that it may be taken advantage of
