Arbitrage is the practice of taking advantage of price differences in different markets by buying low in one market and simultaneously selling high in another. This concept plays a crucial role in ensuring market efficiency, as arbitrageurs help to align prices across various financial instruments, including derivatives like forwards, futures, options, and swaps.
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Arbitrage opportunities arise when there is a discrepancy in the pricing of identical or similar assets across different markets or exchanges.
The existence of arbitrage helps to eliminate price discrepancies, thereby contributing to overall market efficiency.
In the context of derivatives, arbitrage can occur through various strategies, such as exploiting differences between futures and spot prices.
Arbitrageurs must act quickly because price differences are typically short-lived as markets adjust to eliminate the opportunity.
Riskless arbitrage assumes no transaction costs and that the market operates perfectly, which is rarely the case in real-world scenarios.
Review Questions
How does arbitrage contribute to market efficiency in the context of derivatives?
Arbitrage contributes to market efficiency by ensuring that prices of identical or similar assets are aligned across different markets. When arbitrageurs exploit price discrepancies between derivatives and their underlying assets, they buy low and sell high, which forces the prices to adjust accordingly. This process helps eliminate inefficiencies and ensures that all relevant information is reflected in asset prices.
What are some common strategies that arbitrageurs use when trading derivatives like options and futures?
Arbitrageurs commonly use strategies such as cash-and-carry arbitrage, where they take a long position in an asset while simultaneously selling a futures contract, and conversion arbitrage, which involves exploiting mispricing between options and their underlying stocks. These strategies allow arbitrageurs to profit from price differences while minimizing risk. By effectively balancing positions across different markets, they help ensure that prices converge over time.
Evaluate the implications of transaction costs on arbitrage opportunities and market efficiency.
Transaction costs can significantly affect the viability of arbitrage opportunities by reducing potential profits. If the cost of executing trades exceeds the gains from exploiting price discrepancies, arbitrage becomes unfeasible. This reality highlights that while arbitrage plays a crucial role in promoting market efficiency, real-world factors such as transaction fees, taxes, and market liquidity can limit its effectiveness. Therefore, even with price discrepancies present, not all will be acted upon if they do not exceed these costs.
Related terms
Market Efficiency: A condition where asset prices fully reflect all available information, making it difficult for investors to achieve excess returns.
Derivatives: Financial instruments whose value is derived from the performance of an underlying asset, such as stocks or commodities.
Hedging: A risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset.