Lecture 19 - Arbitrage.pdf - Arbitrage Fundamental of...

This preview shows page 1 - 3 out of 8 pages.

Arbitrage Fundamental of Finance L19 1 Outline Arbitrage definitions Arbitrage pricing Arbitrage pricing with transactions costs 2 Arbitrage Definitions In finance theory an “arbitrage” is defined as: A zero investment trading strategy that generates a sure profit: No initial investment Non negative cash flows at all times A positive cash flow at some times On Wall Street “arbitrage” also often means a trading strategy that is expected to make a profit This is also called a “statistical arbitrage” (stat. arb.) In this class: finance theory tradition 3
Image of page 1

Subscribe to view the full document.

Arbitrage Pricing Important insight in finance: There cannot be arbitrage opportunities. If there were, arbitrageurs would trade aggressively to exploit them. Called the “ No Arbitrage Condition ”. Perhaps surprisingly, using the no arbitrage condition alone we can: Compute restrictions on security prices Compute explicitly prices of derivatives. 4 Arbitrage –Example Two risky securities, perfectly negatively correlated Hyper: E[R] = 3%, std = 4% Super: E[R] = 6%, std = 8% Construct risk-free portfolio T-bill: 3% Arbitrage opportunity? 5 Arbitrage –Example If ߩ ൌ െ1: ߪ ݓ ߪሺܴ ݓ ߪሺܴ 0 ൌ ݓ ு௬௣௘௥ ∗ 0.04 ሺ1 െ ݓ ௌ௨௣௘௥ ∗ 0.08 ݓ ு௬௣௘௥ =2/3 ; ݓ ௌ௨௣௘௥ ൌ 1/3 E(R)=2/3*3%+1/3*6%=4% RF gives only 3% Short RF -> buy 2/3 Hyper and 1/3 Super Fundamental of Finance L19 6
Image of page 2
Implications of No Arbitrage Intuition If “something 1” (security, portfolio, trading strategy) has the same cash flow stream as “something 2” (security, portfolio, trading strategy) -> equivalent -> have to have the same price 7 Implications of No Arbitrage 1.
Image of page 3
You've reached the end of this preview.
  • Fall '14
  • EduardoDavila

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern