Understanding Arbitrage : An Intuitive Approach to Financial Analysis

Format: Hardcover
Pub. Date: 2006-01-01
Publisher(s): Wharton School Publishing
List Price: $44.99

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Arbitrage is central both to corporate risk management and to a wide range of investment strategies. Thousands of financial executives, managers, and sophisticated investors want to understand it, but most books on arbitrage are far too abstract and technical to serve their needs. Billingsley addresses this untapped market with the first accessible and realistic guide to the concepts and modern practice of arbitrage. It relies on intuition, not advanced math: readers will find basic algebra sufficient to understand it and begin using its methods. The author starts with a lucid introduction to the fundamentals of arbitrage, including the Laws of One Price and One Expected Return. Using realistic examples, he shows how to identify assets and portfolios ripe for exploitation: mispriced commodities, securities, misvalued currencies; interest rate differences; and more. You'll learn how to establish relative prices between underlying stocks, puts, calls, and 'riskless' securities like Treasury bills - and how these techniques support derivatives pricing and hedging.

Table of Contents

Preface xv
Chapter 1: Arbitrage, Hedging, and the Law of One Price 1(26)
Why Is Arbitrage So Important?
The Law of One Price
The Nature and Significance of Arbitrage
Hedging and Risk Reduction: The Tool of Arbitrage
Mispricing, Convergence, and Arbitrage
Identifying Arbitrage Opportunities
Chapter 2: Arbitrage in Action 27(24)
Simple Arbitrage of a Mispriced Commodity: Gold in New York City Versus Gold in Hong Kong
Exploiting Mispriced Equivalent Combinations of Assets
Arbitrage in the Context of the Capital Asset Pricing Model
Arbitrage Pricing Theory Perspective
Chapter 3: Cost of Carry Pricing 51(24)
The Cost of Carry Model: Forward Versus Spot Prices
Cost of Carry and Interest Rate Arbitrage
Practical Limitations
Chapter 4: International Arbitrage 75(28)
Exchange Rates and Inflation
Interest Rates and Inflation
Interest Rates and Exchange Rates
Triangular Currency Arbitrage
Chapter 5: Put-Call Parity and Arbitrage 103(24)
The Put-Call Parity Relationship
Why Should Put-Call Parity Hold?
Using Put-Call Parity to Create Synthetic Securities
Using Put-Call Parity to Understand Basic Option/Stock Strategies
Chapter 6: Option Pricing 127(36)
Basics of the Binomial Pricing Approach
One-Period Binomial Option Pricing Model
Two-Period Binomial Option Pricing Model
The Black-Scholes-Merton Option Pricing Model
Chapter 7: Arbitrage and the (Ir)Relevance of Capital Structure 163(30)
The Essence of the Theory of Capital Structure Valuation
Measuring the Effect of Financial Leverage
Arbitrage and the Irrelevance of Capital Structure
Options, Put-Call Parity, and Valuing the Firm
References and Further Reading
Index 193


Preface You can make even a parrot into a learned political economist--all he must learn are the two words "supply" and "demand"... To make the parrot into a learned financial economist, he only needs to learn the single word 'arbitrage.' --Stephen A. Ross 1 This book traces the common thread binding together much of financial thought--arbitrage. Distilled to its essence, arbitrage is about identifying mispricing and developing strategies to exploit it. An inherently simple concept--the act of exploiting different prices for the same asset or portfolio--arbitrage is as important as it is commonly misunderstood. This is because arbitrage is so often presented in financial arguments that are long on technical detail but short on economic intuition. Many business professionals' exposure to the concept is limited to the media occasionally associating arbitrage with high-profile financiers, like foreign currency speculator George Soros, or former Secretary of the U.S. Treasury Robert Rubin, once head of arbitrage at Goldman Sachs. Yet such casual mentions do not convey the pervasive importance and usefulness of arbitrage in the world economy or in financial thought. Hence, the goal of this book is to emphasize the intuition of arbitrage and explain how it functions as a common thread in financial analysis. In so doing, I'll provide concrete examples that illustrate arbitrage in action. How do I convey the intuition of arbitrage? In teaching and discussing the concept with many investment professionals, CFA reg; charterholders, CFA candidates, and university students, I have found that arbitrage is best understood by exploring it across the major areas of finance. When you compare and contrast the argument in different applications, the common elements stand in clearer relief, and an integrated picture of arbitrage emerges. Thus, in this book, I explore the role of arbitrage in pricing forward contracts using the cost of carry framework; in examining the relationship among puts, calls, stock, and riskless securities through the put-call parity relation; in understanding foreign exchange rate behavior; in option pricing and strategy; and in understanding corporate capital structure decisions. These topics are of enduring significance in financial thought and in the functioning of the world economy. Indeed, as I discuss in the book, arbitrage-related contributions have garnered several Nobel Prizes in recent years. The benefit of focusing on the intuition of arbitrage comes at a cost. I deal largely with classic arbitrage, which is riskless and self-financing. While I acknowledge various applications called arbitrage that are risky or are not self-financing, departures from classic arbitrage are not emphasized. Yet I discuss how various market frictions can affect the ability to implement classic arbitrage strategies. What remains is a presentation of arbitrage-based arguments and strategies that conveys strong economic intuition, which can fuel further explorations of this pervasively important concept in finance. Chapter 1, "Arbitrage, Hedging, and the Law of One Price," explores the core concepts in arbitrage analysis. The chapter shows that the Law of One Pricedefinesthe resting place for asset prices and that arbitrage is theactionthat draws prices to that resting place. The chapter also explains how hedging is used to reduce or eliminate the risk in implementing an arbitrage strategy and identifies the conditions associated with an arbitrage opportunity. The Law of One Price is shown to impose structure on asset prices through the discipline of the profit motive. Chapter 2, "Arbitrage in Action," illustrates the nature of arbitrage and hedging using several examples, including a

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