Arbitrage

Too good to be true?


The Dream of Arbitrage

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Aswath Damodaran

Aswath Damodaran!

1!

The Essence of Arbitrage

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In pure arbitrage, you invest no money, take no risk and walk away

with sure profits.

You can categorize arbitrage in the real world into three groups:

•  Pure arbitrage, where, in fact, you risk nothing and earn more than the

riskless rate.

•  Near arbitrage, where you have assets that have identical or almost

identical cash flows, trading at different prices, but there is no guarantee

that the prices will converge and there exist significant constraints on the

investors forcing convergence.

•  Speculative arbitrage, which may not really be arbitrage in the first place.

Here, investors take advantage of what they see as mispriced and similar

(though not identical) assets, buying the cheaper one and selling the more

expensive one.

Aswath Damodaran!

2!

Pure Arbitrage

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For pure arbitrage, you have two assets with identical cashflows and

different market prices makes pure arbitrage difficult to find in

financial markets.

There are two reasons why pure arbitrage will be rare:

•  Identical assets are not common in the real world, especially if you are an

equity investor.

•  Assuming two identical assets exist, you have to wonder why financial

markets would allow pricing differences to persist.

•  If in addition, we add the constraint that there is a point in time where the

market prices converge, it is not surprising that pure arbitrage is most

likely to occur with derivative assets – options and futures and in fixed

income markets, especially with default-free government bonds.

Aswath Damodaran!

3!

Futures Arbitrage

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A futures contract is a contract to buy (and sell) a specified asset at a fixed

price in a future time period.

The basic arbitrage relationship can be derived fairly easily for futures

contracts on any asset, by...