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in the price. It is a trade that profits by exploiting price differences of identical or similar
financial instruments, on different markets or in different forms. Arbitrage exists as a
result of market inefficiencies; it provides a mechanism to ensure prices do not deviate
substantially from fair value for long periods of time.
Bull spread -
Bear spread -
Cross hedging – Occurs when the two assets being hedged are different. For example, using
heating oil futures to hedge exposure to jet fuel. Hedge ratio is the ratio of the size of the
position taken in futures to the size of the exposure to jet fuel. When cross hedging used,
hedge ratio is not always 1.
Futures vs Forwards – are prices equal? When are prices equal? When risk free interest rate
is constant and the same for all maturities, then future and forward with same delivery
date is same price. In theory (before), but in practice? What could cause future & forward
price differences aside from risk free interest rate? Taxes, transaction costs, treatment of
margins, risk of default
Options – risk factors affecting price: stock price, strike price, interest rate, volatility, time to
expiration.
- upper bound for option prices (c <= S0, p <= K)
- Put-Call parity (c + Ke-rT = p + S0)
- Put-Call parity with dividends (c + D + Ke-rT = p + S0)