673_04 - SIMPLE ARBITRAGE RELATIONSHIPS FOR FORWARD AND...

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1 SIMPLE ARBITRAGE RELATIONSHIPS FOR FORWARD AND FUTURES CONTRACTS NBA 673 February 2, 2006
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2 Introduction Forwards and futures are similar contracts except for some institutional features. Futures are easier to use, but forwards are easier to price. A forward price can be easily determined from the spot price. Arbitrage is the adhesive that links the two together. Arbitrage = “free lunch.” As the saying goes, there is no such thing.
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3 Arbitrage Arbitrage is any trading strategy requiring no cash input that has some probability of making profits, without any risk of a loss. Example: GM is selling for $60 in US but $61 in Japan. Brokerage cost is $0.25/share. “Buy cheap, sell dear,” and get arbitrage profit $0.50. Arbitrageurs correct such economic disequilibria through profit taking.
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4 “No-Arbitrage” Pricing NOW (time t ) MATURITY (time T ) Or, Portfolio = 0 at time t b Portfolio = 0 at time T Portfolio A Portfolio B Portfolios have same final value No intermediate cash flows Must equal, o/w arbitrage
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5 Assumptions A “fair” price is solved from those portfolios. 4 assumptions are needed for this: A1. No market frictions (no transaction costs, no bid/ask spreads, no margin requirements, no restrictions on short sales, and no taxes). Reasonable approximation for large traders. Simple model - frictions can be added later.
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6 Assumptions (2) A2. No counterparty risks. Reasonable approximation for exchange-traded assets due to clearing houses. A3. Competitive markets. Standard assumption - traders are price takers,
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This note was uploaded on 09/28/2008 for the course NBA 6730 taught by Professor Janosi,tibor during the Spring '06 term at Cornell.

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673_04 - SIMPLE ARBITRAGE RELATIONSHIPS FOR FORWARD AND...

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