FINC3014 � Trading and Dealing in Security Markets

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FINC3014–Trading and Dealing in Security Markets1FINC3014–Trading and Dealing in Security MarketsExplain the concept of arbitrage in trading strategies, focusing on the threecategories of arbitrage: pure arbitrage, near arbitrage, and speculative arbitrage.Use examples from financialmarkets, such as futures or stock index arbitrage, toillustrate each type. Additionally, discuss the risks involved in arbitrage strategies,particularly execution and timing risks.Word count requirement: 800-1,000 words.

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FINC3014–Trading and Dealing in Security Markets2Lecture 11–Trading Strategies and Algorithmic Trading1. EQUITIES ARBITRAGE / TRADING STRATEGIES:Arbitrage:•Theoretically, when prices do not reflect fundamentals, arbitrageprovides the mechanism by which any pricing discrepancies are quicklyeliminated•In practice,arbitrage refers to the profit generating mechanism on pricesthat temporarily deviate from the theoretical or perceived equilibriumrelationshipCategories of Arbitrage:•Pure arbitrage•Near arbitrage•Speculative arbitrageConditions for Arbitrage:•The possibility of arbitrage can only occur when one of three conditionsare met:oThe law of one price does not hold (i.e., the same asset does nottrade at the same price on all markets)oTwo assets with identical cash flowsdo not trade at the same priceoAn asset with a known price in the future does not today trade atits future price discounted at the risk-free interest rate (or, theasset does not have negligible costs of storage; as such, forexample, this condition holds for grain but not for securities).E.g.A stock is traded on both the NYSEEuronextand the London Stock Exchange(LSE).Suppose that the stock price is $172 in New York and₤100in London at a timewhen the exchange rate is $1.7500 per pound.In the absence oftransactions costs, what is the arbitrage opportunity?→Buy in NYSE for $172, sell in London for $175Price Convergence:•Explicit convergence:oThe rate of exchange of one asset for another is known withcertainty at a given time in the futureoE.g.Stock splits and mergers▪In either case, the time frame for convergence is obvious asit is the conversion date•Absolute convergence:oThe value of an asset is known with certainty at a given point intimeoE.g.Futures and options▪They must converge to their cash value at maturity▪Thus, the contract expiry date provides the convergence

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FINC3014–Trading and Dealing in Security Markets3time frame•Hypothetical Convergence:oRelies on identifying long run relationships between assetsoWhere their prices have temporarily diverged, profitable tradingopportunities existoBy buying (selling) the asset whose value has fallen (risen) relativeto the long run equilibrium value, profits can be madeRisks of Arbitrage:•Execution risks•Timing risksPURE ARBITRAGE:•For pure arbitrage, you have two assets with identical cash flows anddifferent market prices•Pure arbitrage difficult to find in financial marketsDeterminants of success of pure arbitrage•Access to real-time prices•Instantaneous execution (minimal latency)•Access to substantial debt at risk-free rate•Economies of scaleMarkets where pure arbitrage is feasible:•Futures markets:•Options market•Fixed income marketsFutures arbitrage (stock futures andstock):•Futures contract:a contract to buy (and sell) a specified asset at a fixedprice in a future time periodWhat price would the investor be prepared to pay for a futures contract on aninvestment asset (with no income)?What price would the investor be prepared to pay for a futures contract on aninvestment asset (with income)?

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