Question

Explain what is meant by the term Arbitrage and why the idea of markets being arbitrage free is required for derivatives valuation?

Answer 1

Answer: Arbitrage- It is the strategy of taking advantage of price discrepancy of two different markets. It is the strategy of simultaneously buying and selling of an asset from different markets. In the arbitrage, quantity remains same but price differs. Arbitrage is a profit making strategy but it is rare, it does not happen usually. In arbitrage, profit should cover the transaction cost. Arbitrage is an opportunity to make money, traders have to seek and analyze that opportunity. Profit from arbitrage is considered risk free profit.

Arbitrage can be used for stocks, commodities, currencies and derivatives.

The idea of markets being arbitrage free is required for derivatives valuation- Arbitrage free valuation is valuing an asset without consideration of arbitrage opportunity.

In the derivative markets, arbitrage happens when there is price difference between a derivative and a portfolio of asset that replicate the cash flows of derivative, derivatives are priced using no-arbitrage principle so that no trader can make a risk free profit because price of derivative security is set at the same level as the value of replicating portfolio. Arbitrage can inflate the fair price of asset.