Question

1. Describe the riskless arbitrage strategies, that will yield the CAPM alpha and the Carhart alpha as the expected return. (Hint: The momentum factor buys recent winners and shorts recent losers)

2. Do you think that the alpha from question 1 overesitamtes or underesimates the abnormal return you should expect to get from the short side of your stratgy going forward? (Hint: think about what is likely to have happend to the stocks you decided to short. The loading on the momentum factor may help in answering this question.)

Answer 1

Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices. This is considered riskless profit for the investor/trader.

Some of the simplest form of arbitrage are :

Geographical arbitrage : A common product/ stock may have differential prices at different geographical locations. So just hold a long position in the market having lower price and short position in the market having higher price.

Merger arbitrage :

Also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates

Cross-border arbitrage : It is as same as of the geographical or Spatial arbitrage but the location behing the country. The same stock may have the differential price in the split of countries.

Regulatory arbitrage : Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position.