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Arbitrage

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Definition of Arbitrage

Arbitrage Image 1

Arbitrage

The purchase of securities on one market for immediate resale on
another market in order to profit from a price or currency discrepancy.


Arbitrage

The simultaneous buying and selling of a security at two different prices in two different markets,
resulting in profits without risk. Perfectly efficient markets present no arbitrage opportunities. Perfectly
efficient markets seldom exist.


Arbitrage

Transactions designed to make a sure profit from inconsistent prices.



Related Terms:

Arbitrage-free option-pricing models

Yield curve option-pricing models.


Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.


Arbitrageurs

People who search for and exploit arbitrage opportunities.



Covered interest arbitrage

A portfolio manager invests dollars in an instrument denominated in a foreign
currency and hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for
dollars.


Currency arbitrage

Taking advantage of divergences in exchange rates in different money markets by
buying a currency in one market and selling it in another market.


Arbitrage Image 2

Index arbitrage

An investment/trading strategy that exploits divergences between actual and theoretical
futures prices.


Risk arbitrage

Speculation on perceived mispriced securities, usually in connection with merger and
acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis are all hardcore arbs. They
had a huge BT/MCI position in the summer of 1997, and came out smelling like roses.


Risk controlled arbitrage

A self-funding, self-hedged series of transactions that generally utilize mortgage
securities as the primary assets.


Riskless arbitrage

The simultaneous purchase and sale of the same asset to yield a profit.


Structured arbitrage transaction

A self-funding, self-hedged series of transactions that usually utilize
mortgage securities as the primary assets.


Triangular arbitrage

Striking offsetting deals among three markets simultaneously to obtain an arbitrage profit.


American Depositary Receipts (ADRs)

Certificates issued by a U.S. depositary bank, representing foreign
shares held by the bank, usually by a branch or correspondent in the country of issue. One ADR may
represent a portion of a foreign share, one share or a bundle of shares of a foreign corporation. If the ADR's
are "sponsored," the corporation provides financial information and other assistance to the bank and may
subsidize the administration of the ADRs. "Unsponsored" ADRs do not receive such assistance. ADRs carry
the same currency, political and economic risks as the underlying foreign share; the prices of the two, adjusted for the SDR/ordinary ratio, are kept essentially identical by arbitrage. American depositary shares(ADSs) are
a similar form of certification.


Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.


Lifting a leg

Closing out one side of a long-short arbitrage before the other is closed.


One-factor APT

A special case of the arbitrage pricing theory that is derived from the one-factor model by
using diversification and arbitrage. It shows the expected return on any risky asset is a linear function of a
single factor.


Perfect capital market

A market in which there are never any arbitrage opportunities.



Put-call parity relationship

The relationship between the price of a put and the price of a call on the same
underlying security with the same expiration date, which prevents arbitrage opportunities. Holding the stock
and buying a put will deliver the exact payoff as buying one call and investing the present value (PV) of the
exercise price. The call value equals C=S+P-PV(k).


Spot futures parity theorem

Describes the theoretically correct relationship between spot and futures prices.
Violation of the parity relationship gives rise to arbitrage opportunities.


Yield curve option-pricing models

Models that can incorporate different volatility assumptions along the
yield curve, such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing models.


Zero-investment portfolio

A portfolio of zero net value established by buying and shorting component
securities, usually in the context of an arbitrage strategy.



 

 

 

 

 

 

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