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Foundations of Financial Markets

Class 9

ARBITRAGE AND REPLICATION


Class Outline The Principle of Arbitrage Three Examples Limits to Arbitrage Reading BKMe6: 8.4 (pp.262-264), 14.1, 14.2 (pp.473-475), 15.3 (pp.519-521), 16.1, 16.4 (pp.551-554) BKMe7: 9.1 (pp.267-272), 15.1, 15.2 (pp.486-488), 16.3 (pp.533-536), 17.1, 17.4 (pp.566-570) Professor John C. Handley

1.

THE PRINCIPLE OF ARBITRAGE

Arbitrage An arbitrage is a trading strategy which costs nothing today but has the expectation of a cash inflow later with no chance of a cash outflow later. Also called a free lunch or something for nothing Compare the pattern of cash flows on the following trading strategies:
Trading Strategy Buy shares now and sell them later Short sell shares now and buy them back later Arbitrage strategy I Arbitrage strategy II Cash Now

+ 0 0

Cash Later

(but only in some states of the world)

+ + +

These are also arbitrage strategies


Arbitrage strategy III Arbitrage strategy IV

+ +

0 +
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The trading strategy usually involves the sale of one or more assets at a relatively high price and the simultaneous purchase of the same assets (or their equivalent) at a relatively low price. In seeking to exploit an arbitrage opportunity, the buying and selling actions of investors drives the prices together until the arbitrage disappears. The Law of One Price (LOOP) Assume the current (time 0) price of asset X is X 0 and the current price of asset Y is Y0 . Further assume that the random payoff on asset X at time 1 is X 1 and the random payoff on asset Y at time 1 is Y1 . LOOP states that if X 1 = Y1 then X 0 = Y0 otherwise an arbitrage opportunity is available i.e. if two assets have identical cash flows in the future then they must trade at the same price today
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Assume X 1 = Y1 . What would you do if you observe that X 0 > Y0 ?

Action

Cash Now t =0

Cash Later t =1

Net Cash flow

LOOP is a statement about the relative prices of two or more assets In the above case, the action of arbitrageurs would create selling pressure which would drive down the price of X and buying pressure which would drive up the price of Y until the prices of the two assets equate and no further arbitrage is possible. LOOP says the prices equate but it says nothing about at which price this occurs. An Important Application of LOOP Valuation By Replication If you can replicate (or copy) the future cash flows on one asset (or portfolio of assets) using the cash flows on some other asset (or portfolio of assets) then the current value of the first is equal to the current value of the second otherwise there is an arbitrage sometimes a static replication is used you replicate the cash flow by setting up the appropriate strategy at the start of the period (and then settle at the end) and sometimes a dynamic replication is used you replicate the cash flow by setting up the appropriate strategy at the start of the period and you need to periodically rebalance the strategy over the period (and then settle at the end).
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Replication and hedging are related concepts you can hedge a long position in an asset by replicating a short position in that asset more on this later. The Assumption of No Arbitrage (NA) Arbitrage is a fundamental force in financial markets Arbitrage opportunities should be rare in well functioning financial markets with rational investors who prefer more wealth to less But when an arbitrage does arise, it tends to disappear very quickly as the buying and selling actions of investors cause the relevant asset prices to adjust why ? NA may be used to determine:

an upper and or lower bound on the price of an asset the price of an asset

In fact, many standard pricing models used in practice (such as those dealing with options, futures, interest rates, foreign exchange rates) are based on an assumption of no arbitrage
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With its emphasis on the absence of arbitrage, neoclassical finance takes a step back from the requirement that the markets be in full equilibrium The study of the implications of NA is the meat and potatoes of modern finance Stephen Ross 1
Technical Note: Relationship between LOOP and NA: LOOP is an important special case of NA (equivalently NA is a more general concept than LOOP) because arbitrage is not restricted to circumstances where the two assets have identical payoffs. NA is a necessary condition for an equilibrium in a financial market (i.e. if an arbitrage exists then by definition, the market is not in equilibrium since there will be an excess demand for at least one asset and an excess supply for at least one other asset)

Arbitrage and Risk Arbitrage A (pure) arbitrage is one where the investor expects to make a gain with no risk. A risk arbitrage involves an element of speculation (usually concerning the relative mispricing of one or more assets) and so involves some risk
Technical Note: A gain is expected if (i) there will be a gain in all states of the world or (ii) there will be a gain in only some states of the world but there will be no loss in the other states of the world.

Ross, Stephen A., 2004, Neoclassical Finance, p.2. 7

2.

THREE EXAMPLES

The principle of arbitrage extends across all financial markets we will draw on three examples involving derivative securities
2.1 Put-Call Parity

Option A (contractual) agreement which gives one party the right but not the obligation to exchange a specified asset, with the other party, at a specified price at a specified date we will focus on options on common stocks for simplicity Long and Short Positions The person who has bought the option is said to have taken a long position in the option or is long option The person who has sold the option has taken a short position in the option or is short option.
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The price paid at the time of entering the contract is called the premium. The decision whether to exercise the option or not rests with the long. the short must comply with the decision of the long. Types of Options A call option gives the long the right but not the obligation to buy the stock from the short at the time of exercise
$ strike Long Option stock Short Option

A put option gives the long the right but not the obligation to sell the stock to the short at the time of exercise
$ strike Long Option stock Short Option
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When Can the Option be Exercised ? The last date that the option can be exercised is the expiry or maturity date. ... if not exercised at maturity, then all contractual rights and obligations cease. A European option may be exercised only at maturity An American option may be exercised at any time up to and including maturity A Bermudan option may be exercised only at a finite number of pre-specified dates up to and including maturity or over some pre-specified period prior to maturity
Enter Contract Allowable dates European American Bermudan
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Maturity

The maturity date of an option contract is fixed as time passes, we get closer to the maturity date and so the time to maturity (or life of the option) decreases Value of an Option at Maturity There are four basic option positions: (i) (ii) (iii) (iv) Long call Long put Short call Short put

The value of an option at maturity depends on whether it is exercised at that time. The long will exercise an option at maturity if it has a positive value at that time so, the value of an option and the decision to exercise are determined simultaneously and this depends on a comparison of the stock price at maturity with the strike price of the option

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If ST is the stock price at maturity and X is the strike price of the option then: Position Long call Short call Long put Short put This means the value of a long call at maturity is the value of a long put at maturity is the value of a short call at maturity is the value of a short put at maturity is Value of option at maturity if ST X ST > X ST X 0 ( ST X ) 0 X ST 0 ( X ST ) 0 Exercise the option if ST > X
ST X

CT = max ( 0, ST X ) PT = max ( 0, X ST )
CT PT
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Payoff Diagrams A graphical representation of the value (or payoff) of an option at maturity
Long call Short call

Long put

Short put

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Put-Call Parity (PCP) PCP specifies the relationship between the price of a call option and the price of a put option on the same stock with the same strike price and with the same time to maturity. Established by arbitrage arguments Consider a European call option (with a strike of X and maturity T years from now) and a European put option (with a strike of X and maturity T years from now) both on a stock with current price S0 . Assume the risk-free rate is constant at rf % per annum and the stock is not expected to pay any dividends over the next T years. Then, in the absence of arbitrage:
X

C0E = P0E + S0 PV ( X )

where

PV ( X ) =

(1 + r )
f

where C0E is the current price of the call and P0E is the current price of the put.
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Proof Consider the cash flows (now and at maturity) on the following two portfolios: you buy the call and sell the put you buy the stock and borrow an amount equal to the present value of the strike for a period of T years at an interest rate of rf % per annum with repayment (of interest and principal) due at the end of the loan Action
1st Portfolio

Cash flow Now Buy call Sell put Net

Cash flow at Maturity ST X ST > X

2nd Portfolio

Buy stock Borrow Net

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By LOOP, the current values of the two portfolios must be the same otherwise there is an arbitrage

An additional benefit of the arbitrage proof is that it also shows the strategy to be followed if PCP does not hold. For example assume you observe market prices such that:
C0E > P0E + S0 PV ( X )

what would you do ?

Technical Notes: PCP can readily be extended for stocks which pay dividends which are certain to be paid or if interest rates are stochastic or if the options are American rather than European. In the later case, rather than a parity relation between call and put prices we end up with upper and lower bounds on one in terms of the other. Uncertain dividends introduce a source of risk into the relationship.

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2.2 The Lower Bound on the Price of a European Call Option

Consider a European call option with a strike of X and maturity T years (from now) on a stock with current price S0 . Assume markets are frictionless and, for simplicity, the risk-free rate is constant at rf % per annum and the stock is not expected to pay any dividends over the next T years. Then, in the absence of arbitrage:
C0E max ( 0, S0 PV ( X ) )

where

PV ( X ) =

(1 + r )
f

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Example A 1-year European call (strike $18) currently trades for $3.00. The current stock price is $20 and the risk free rate of interest is 10% per annum. Show the following trading strategy is an arbitrage Action Cash Now t =0 Cash Later t =1 ST X ST > X

Buy 1 call Sell 1 stock Invest PV(X) in 1 year risk free bonds Net Cash

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How Do You Identify This Arbitrage Opportunity ? Assume C0E > 0 and S0 PV ( X ) > 0 but
C0E < S0 PV ( X )

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What if the Option Has a Negative Price ? If C0E < 0 (and regardless of whether S0 PV ( X ) is positive or negative) then there is a very easy arbitrage strategy you simply buy the option. This gives you a positive cash flow now and possibly another positive cash flow at maturity Action
Cash Now t =0 Cash Later t =1 ST X ST > X

Buy 1 call

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An Aside: Modus Tollens Consider two statements, A and B. Modus tollens is a rule of logic which states If
A B

then

not B not A

For example, let statement A be today is Tuesday and let statement B be today is not Friday then Derivation of the Lower Bound We know that if C0E > 0 and S0 PV ( X ) > 0 then
C0E < S0 PV ( X ) implies arbitrage opportunity

So by modus tollens No arbitrage opportunity implies C0E S0 PV ( X )


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We also know that

C0E < 0

implies arbitrage opportunity

Again by modus tollens No arbitrage opportunity implies C0E 0 Combining leads to the lower bound:
C0E max ( 0, S0 PV ( X ) )

A similar approach can be used to derive the lower bound on the price of a European Put Option:
P0E max ( 0, PV ( X ) S0 )
Technical Notes: Lower bounds can also be derived in the case of stocks which pay (certain) dividends or if interest rates are subject to random changes or if the options are American rather than European.
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2.3 Spot-Forward Parity

Spot Contract An agreement to exchange a specified asset at a specified price immediately on the spot e.g. you buy a stock at the current spot price S0
Technical Note: With many financial securities, paperwork requirements means that settlement may not actually occur until a few days later

Forward Contract An agreement to exchange a specified asset at a specified price at a specified later date e.g. you buy a forward on a stock at the current forward price F0 exchange one party buys and the other party sells i.e. there is no choice The maturity date of a forward contract is fixed as time passes, we get closer to the maturity date and so the time to maturity (or life of the forward) decreases
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The Forward Price The forward price represents the price at which the asset is exchanged at maturity. The forward price does not represent the price you pay at the time you buy a forward contract (or the price you receive at the time you sell a forward contract). in fact, it costs nothing to enter a forward contract but we still talk in terms of buying or selling a forward even though no cash is exchanged at that time. The forward price of an asset, like the spot price of an asset changes over time But once a contract is entered into then the forward price on that contract is locked in and this locked in price is referred to as the delivery price K

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Spot Contracts vs. Forward Contracts A forward contract differs from a spot contract in so far as there is "deferred payment" of the price and "deferred delivery" of the asset

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Value of a Forward at Maturity There are two basic forward positions: (i) Long forward; (ii) Short forward At maturity, the long is obliged to buy and the short is obliged to sell the stock at the delivery price
$ delivery Long Forward stock Short Forward

The value of a forward position at maturity depends on the relationship between the delivery price K and the stock price ST at that time. the value of a long forward at maturity is the value of a short forward at maturity is
fT = ST K fT = K ST

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which can be represented graphically by the following payoff diagrams


Long forward Short forward

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Spot-Forward Parity Also called spot-futures parity or the cost of carry Describes the relationship between the forward price and spot price of an asset. Consider a forward contract (which matures T years from now) on a stock with current price S0 . Assume the risk-free rate is constant at rf % per annum and the stock is not expected to pay any dividends over the next T years. Then, in the absence of arbitrage:
F0 = S0 (1 + rf

where F0 is the current forward price.

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Proof Consider the cash flows (now and at maturity) on the following two portfolios: you buy the forward F0 you buy the stock and borrow an amount equal to for a period of T T

(1 + r )
f

years at an interest rate of rf % per annum with repayment (of interest and principal) due at the end of the loan
Action
1st Portfolio

Cash flow Now

Cash flow at Maturity

Buy forward
2nd Portfolio

Buy stock Borrow Net LOOP the current values must equal otherwise there is an arbitrage
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3.

LIMITS TO ARBITRAGE

Standard NA models are based on a number of simplifying assumptions including frictionless markets. In reality, there are a number of market features which may introduce risk into what otherwise would be a pure arbitrage opportunity and so in turn limits the ability of arbitrageurs to take full take advantage of the apparent arbitrage: various restrictions on short selling of assets (for example, the requirement to post collateral effectively limiting access to the whole proceeds from the short sale) potential for margin calls (for example, it is assumed that the prices of two perfect substitutes will converge but this may not occur exactly or may not occur within the investors time horizon or prices may diverge even further before converging) delays in implementing the required trades on a simultaneous basis counterparty default risk Pure arbitrage and risk arbitrage are also both subject to model risk a relative mispricing of one or more assets is typically identified on the basis of some assumed model of asset prices but the model may not be completely correct !!
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