What is Arbitrage?

Arbitrage is the ability to make riskless

profit.
No Arbitrage Principle
In other words, arbitrage allows the
individual or set of individuals to enter into
Sankarshan Basu a trading deal and ensure that there shall be
a profit without taking any risk associated
with the deal.

Arbitrage Example 1
Some points about Arbitrage
• A stock price is quoted as £100 in London
• Arbitrage exists due to mismatch of information in the
market or due to the availability of some specific
and $172 in New York
information by a select group of individuals. • The current exchange rate is 1.7500
• A well functioning market shall not allow the arbitrage
opportunity to survive for very long – it shall automatically
• What is the arbitrage opportunity?
correct itself. – Buy the stock in New York at $172. This works
• However, there are a group of people in the market who out to less than £100. Thus one can sell the
would always look for some arbitrage opportunities and stock in London for £100 thus making a profit.
make money through that avenue – basically these are the
arbitrageurs.

Example 2: Gold: An Arbitrage Example 3: Gold: Another

Opportunity? Arbitrage Opportunity?
• Suppose that: • Suppose that:
- The spot price of gold is US$300 - The spot price of gold is US$300
- The 1-year forward price of gold is - The 1-year forward price of gold is
US$340 US$300
- The 1-year US$ interest rate is 5% - The 1-year US$ interest rate is 5%
per annum per annum
• Is there an arbitrage opportunity? • Is there an arbitrage opportunity?

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 The Forward Price of Gold
If the spot price of gold is S & the forward price for a
contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free
rate of interest.
In our examples, S=300, T=1, and r=0.05 so that
F = 300(1+0.05) = 315
Example 4: Oil: An Arbitrage
Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of oil
is US$25
- The 1-year US$ interest rate is 5%
per annum
- The storage costs of oil are 2% per
annum
• Is there an arbitrage opportunity?
Calls: An Arbitrage Opportunity?
What happens in Examples 4 & 5
• Arbitrage opportunity exists in Example 4 –
what is the level of arbitrage?
• However, it does not exist in example 5
So what happens in Examples 2 and 3 …
• Example 2: The forward price of gold (as per formula
based on riskless investments) is $315 where as the quoted
1 year forward price of gold is $340. Hence, one can make
a profit of $25 ($340 - $315) by buying gold now in the
spot market at current prices of $300 and agreeing to sell
the gold in 1 years time at the current forward rate of $340.
• Example 3: The forward price of gold (as per formula
based on riskless investments) is $315 where as the quoted
1 year forward price of gold is $300. Hence, one loses $15
($300 - $315) by buying gold now in the spot market at
current prices of $300 and agreeing to sell the gold in 1
years time at the current forward rate of $300.
Example 5: Oil: Another
Arbitrage Opportunity?
• Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of oil
is US$16
- The 1-year US$ interest rate is 5%
per annum
- The storage costs of oil are 2% per
annum
• Is there an arbitrage opportunity?
• Suppose that
c =3 S0 = 20
T =1 r = 10%
X = 18 D=0
• Is there an arbitrage opportunity?
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 Calls: An Arbitrage
Lower Bound for European Call
Opportunity? (contd.)
Option Prices; No Dividends
• Call Price = S0 – X e-rT = 20 – 18 e-0.1 = 3.71
• Market quoted price of the call is 3 (< 3.71).
• An arbitrageur can then buy the call and short the stock.
This will provide an inflow of (20 – 3) = 17. Now, invest
17 at 10% for a year and this becomes 17 e-0.1 = 18.79. c  S0 -Xe -rT
• At the end of 1 year if price is above 18, the exercise the
call and buy the stock at 18 thus making a profit of 0.79
• If price is less than 18, then close the short position by
buying from the market and letting the call expire
worthless – profit is much more.

Puts: An Arbitrage
Puts: An Arbitrage
Opportunity?
Opportunity? (contd.)
• Suppose that • Put Price = X e-rT - S0 = 40 e-(0.05 *0.5) – 37 = 2.01
p =1 S0 = 37 • Market quoted price of the put is 1 (< 2.01).
T = 0.5 r =5% • An arbitrageur can then borrow 38 for 6 months to buy
X = 40 D =0 both the put and the stock.
• At the end of 6 months, he will be required to pay 38 e-(0.05
*0.5) = 38.96.
• Is there an arbitrage • If price is below 40, the exercise the put and sell the stock
opportunity? for 40 and repay the loan of 38.96, making a profit of 1.04.
• If price is above 40, discard the option and sell the stock
and repay the loan – profit is much more.

Lower Bound for European

Put-Call Parity; No Dividends
Put Prices; No Dividends
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + PV of the strike
price in cash (X e-rT )
– Portfolio B: European put on the stock + the stock

p  Xe -rT - S0 • Both are worth MAX(ST , X ) at the maturity of the options

• They must therefore be worth the same today
– This means that
c + Xe -rT = p + S0

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 Arbitrage Opportunities
Solutions to the first scenario
• Suppose that
• p = 2.25
c =3 S0 = 31  c + X e-rT = 3 + 30 e-0.1*0.25 = 32.26
T = 0.25 r = 10% and p + S0 = 2.25 + 31 = 33.25
Thus portfolio B is overpriced relative to A. The correct arbitrage
X =30 D =0 strategy will then be to buy securities in A and short the securities in B.
This involves buying the call and shorting both the put and the stock.
• What are the arbitrage This generates a positive cash flow of
-3 + 2.25 + 31 = 30.25
possibilities when which at 10% in 3 months grows to
p = 2.25 ? 30.25 e0.1*0.25 = 31.02
If stock price > 30, then call is exercised, else put is exercised. In either
p =1? case, the investor ends up buying one share for 30 which can then be
used to close out the short position. Thus the profit is:
31.02 – 30 = 1.02

Solutions to the second scenario Extensions of Put-Call Parity

• p=1 • American options; D = 0
 c + X e-rT = 3 + 30 e-0.1*0.25 = 32.26
and p + S0 = 1 + 31 = 32 S0 - X < C - P < S0 - Xe -rT
Here, portfolio A is overpriced relative to B. The correct arbitrage
strategy will then be to short securities in A and buy securities in B to
lock in a profit. This involves shorting the call and buying both the put • European options; D > 0
and the stock. This strategy has an initial investment at time zero of
31 + 1 – 3 = 29 c + D + Xe -rT = p + S0
At 10% in 3 months the repayment amount is
29 e0.1*0.25 = 29.73
As in the first case, either the call or the put will be exercised. The • American options; D > 0
short call and log put position therefore leads the stock being sold for
30. The net profit is thus: S0 - D - X < C - P < S0 - Xe -rT
30 – 29.73 = 0.27