No Arbitrage Principle

Sankarshan Basu

What is Arbitrage?
Arbitrage is the ability to make riskless
profit.
In other words, arbitrage allows the
individual or set of individuals to enter into
a trading deal and ensure that there shall be
a profit without taking any risk associated
with the deal.

Some points about Arbitrage

Arbitrage exists due to mismatch of information in the
market or due to the availability of some specific
information by a select group of individuals.
A well functioning market shall not allow the arbitrage
opportunity to survive for very long it shall
automatically correct itself.
However, there are a group of people in the market who
would always look for some arbitrage opportunities and
make money through that avenue basically these are the
arbitrageurs.

Arbitrage Example 1
A stock price is quoted as 100 in London
and $172 in New York
The current exchange rate is 1.7500
What is the arbitrage opportunity?
Buy the stock in New York at $172. This works
out to less than 100. Thus one can sell the
stock in London for 100 thus making a profit.

Example 2: Gold: An Arbitrage

Opportunity?
Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold is
US$340
- The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

Example 3: Gold: Another

Arbitrage Opportunity?
Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold is
US$300
- The 1-year US$ interest rate is 5%
per annum
Is there an arbitrage opportunity?

The Forward Price of Gold

If the spot price of gold is S & the forward price for a
contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free
rate of interest.
In our examples, S=300, T=1, and r=0.05 so that
F = 300(1+0.05) = 315

So what happens in Examples 2 and 3

Example 2: The forward price of gold (as per formula
based on riskless investments) is $315 where as the quoted
1 year forward price of gold is $340. Hence, one can make a
profit of $25 ($340 - $315) by buying gold now in the spot
market at current prices of $300 and agreeing to sell the
gold in 1 years time at the current forward rate of $340.
Example 3: The forward price of gold (as per formula
based on riskless investments) is $315 where as the quoted
1 year forward price of gold is $300. Hence, one loses $15
($300 - $315) by buying gold now in the spot market at
current prices of $300 and agreeing to sell the gold in 1
years time at the current forward rate of $300.

Example 4: Oil: An Arbitrage

Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of oil
is US$25
- The 1-year US$ interest rate is 5%
per annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

Example 5: Oil: Another

Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of oil
is US$16
- The 1-year US$ interest rate is 5%
per annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

What happens in Examples 4 & 5

Arbitrage opportunity exists in Example 4
what is the level of arbitrage?
However, it does not exist in example 5

Calls: An Arbitrage Opportunity?

Suppose that
c =3
T =1
X = 18

S0 = 20
r = 10%
D=0

Is there an arbitrage opportunity?

Calls: An Arbitrage
Opportunity? (contd.)
Call Price = S0 X e-rT = 20 18 e-0.1 = 3.71
Market quoted price of the call is 3 (< 3.71).
An arbitrageur can then buy the call and short the stock.
This will provide an inflow of (20 17) = 3. Now, invest
17 at 10% for a year and this becomes 17 e-0.1 = 18.79.
At the end of 1 year if price is above 18, the exercise the
call and buy the stock at 18 thus making a profit of 0.79
If price is less than 18, then close the short position by
buying from the market and letting the call expire
worthless profit is much more.

Lower Bound for European Call

Option Prices; No Dividends
c S0 -Xe -rT

Puts: An Arbitrage
Opportunity?
Suppose that
p =1
T = 0.5
X = 40
Is there an arbitrage
opportunity?

S0 = 37
r =5% X
D =0

Puts: An Arbitrage
Opportunity? (contd.)
Put Price = X e-rT - S0 = 40 e-(0.05 *0.5) 37 = 2.01
Market quoted price of the put is 1 (< 2.01).
An arbitrageur can then borrow 38 for 6 months to buy both
the put and the stock.
At the end of 6 months, he will be required to pay 38 e-(0.05
*0.5) = 38.96.
If price is below 40, the exercise the put and sell the stock
for 40 and repay the loan of 38.96, making a profit of 1.04.
If price is above 40, discard the option and sell the stock
and repay the loan profit is much more.

Lower Bound for European

Put Prices; No Dividends

p Xe -rT - S0

Put-Call Parity; No Dividends

Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of the strike
price in cash (X e-rT )
Portfolio B: European put on the stock + the stock
Both are worth MAX(ST , X ) at the maturity of the options
They must therefore be worth the same today
This means that

c + Xe -rT = p + S0

Arbitrage Opportunities
Suppose that
c =3

S0 = 31

T = 0.25
r = 10%
X =30
D =0
What are the arbitrage
possibilities when
p = 2.25 ?
p =1?

Solutions to the first scenario

p = 2.25
c + X e-rT = 3 + 30 e-0.1*0.25 = 32.26
and p + S0 = 2.25 + 31 = 33.25
Thus portfolio B is overpriced relative to A. The correct arbitrage strategy
will then be to buy securities in A and short the securities in B. This involves
buying the call and shorting both the put and the stock. This generates a
positive cash flow of
-3 + 2.25 + 31 = 30.25
which at 10% in 3 months grows to
30.25 e0.1*0.25 = 31.02
If stock price > 30, then call is exercised, else put is exercised. In either case,
the investor ends up buying one share for 30 which can then be used to close
out the short position. Thus the profit is:
31.02 30 = 1.02

Solutions to the second scenario

p=1
c + X e-rT = 3 + 30 e-0.1*0.25 = 32.26
and p + S0 = 1 + 31 = 32
Here, portfolio A is overpriced relative to B. The correct arbitrage strategy
will then be to short securities in A and buy securities in B to lock in a profit.
This involves shorting the call and buying both the put and the stock. This
strategy has an initial investment at time zero of
31 + 1 3 = 29
At 10% in 3 months the repayment amount is
29 e0.1*0.25 = 29.73
As in the first case, either the call or the put will be exercised. The short call
and log put position therefore leads the stock being sold for 30. The net profit
is thus:
30 29.73 = 0.27

Extensions of Put-Call Parity

American options; D = 0
S0 - X < C - P < S0 - Xe -rT
European options; D > 0
c + D + Xe -rT = p + S0
American options; D > 0
S0 - D - X < C - P < S0 - Xe -rT