Literature

A LITERATURE REVIEW OF ARBITRAGE

In economics and finance, arbitrage is the practice of purchasing and selling the same or similar financial securities at the same time, but in two or more different markets. Sharpe and Alexander (1990) suggested that the arbitragers make profits through the price differences among different markets. Arbitrage plays a significant important role in analysing financial markets. But when it comes to the questions like whether arbitrage practices are risk free, are there any cost of arbitrage and what the benefits of arbitrage are, different experts hold different opinions. This paper is divided into three sections, section 1 lays out the benefits of the arbitrage. Section 2 discusses the limits of the arbitrage, from two sides which are the cost of arbitrage and the risk of arbitrage. Finally, the section 3 is the conclusion part.

1. The Benefits of Arbitrage

According to Shleifer and Vishny (1997), theoretically speakingthere is no risk of arbitrage practices and even no capital is needed. Because the arbitragers can earn a risk free profit through such a process: they buy the financial securities in the market with lower price and sell them in the market which has a higher price. By using the strategy of buying at low price and sell at high price, the arbitragers can earn a profit without bearing any risk and their net cash flow is zero. In addition, they also show that arbitrage plays a critical role in promoting the efficiency of financial markets by pushing the prices to their true value.

Mitchell and Pulvino (2001) show that the risk arbitrage is an investment strategy that tries to get profits from the arbitrage spread which is the difference between the selling price and the

price of target’s stock. According to them, many academic studies suggest that investors can earn substantial excess returns from risk arbitrage activities. Moreover, they study also show that risk arbitragers can have an average excess return...