Bonds and Bond Derivatives, Second Edition

8

ARBITRAGE

One of the most important concepts in finance is the concept of arbitrage, also called the law of one price. In frictionless markets, the same asset must have one price at a particular instant in time, no matter where it is traded. As a simple example, consider a common stock traded on both the New York Stock Exchange and the Pacific Stock Exchange. If the stock has a price of $50 in New York and $53 on the Pacific Exchange, an arbitrager can simultaneously buy the stock at $50 and sell (shortsell) it at $53, for an immediate and risk-free profit of $3. The purchase at $50 and the sale at $53 drive the prices together. An arbitrager does not need any capital to make arbitrage profits. Therefore, one small arbitrager who repeatedly and rationally exploits price differences is able to drive the prices together.

Arbitrage is clearest in a world of frictionless financial markets, when the following assumptions will hold: (1) no taxes, (2) no default risk, (3) no transaction costs or storage costs, and (4) unrestricted shortselling (defined below) allowed. In practice, markets are not frictionless. Frictions can create differences between the prices of the same thing in different markets. Thus, a stock trading in New York and on the West Coast may have slightly different prices because of the transaction costs of buying in the lower-priced market and selling in the higher-priced market.

This chapter presents several examples of arbitrage linking the prices in different markets. ...