Arbitrage
Buying and selling equivalent things at different prices for a profit that carries no risk. Its existence is what forces prices into line.
Where you will meet it
Arbitrage appears in 27 learning outcomes on the CFA syllabus. A few of them:
- Explain multi-factor models and arbitrage pricing theory as used for equities
“Arbitrage pricing theory generalises the CAPM: expected return is the risk-free rate plus the sum of each factor sensitivity multiplied by that factor's risk premium, E(R) = Rf + b1 x RP1 + b2 x RP2 and so on.”
- Work out forward rates from a set of spot rates
“No arbitrage requires the two to be equal, which pins the implied forward rate: one plus the two-year spot rate, squared, equals one plus the one-year spot rate multiplied by one plus the one-year forward rate one year forward.”
- Explain cash flow additivity and apply it to derive an implied forward rate
“It follows that two strategies producing identical cash flows must cost the same, or an arbitrage profit is available.”
- Show how the absence of arbitrage fixes a forward price
“If the quoted price departs from that, the arbitrage is mechanical — buy the cheap side, sell the dear one, and the two positions cancel at delivery leaving the difference.”
Practise it
Practise arbitrage until it is automatic: questions that explain every wrong option.
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