Arbitrage is a kind of hedging technique used in investment management.
In general simultaneous selling and buying of stocks to offset losses is referred to as arbitrage. sometimes it helps us achieve profit with less risk.
FRM AIM: Calculate an arbitrage payoff and describe how arbitrage opportunities are ephemeral (i.e., short lived)
Speculators
- Take positions in the market to profit from the positions
- There might be large gain/loss when speculators use futures as a hedge against the underlying securitys
- The maximum loss when speculators use options as hedging strategy is limited to the cost of the option itself
- Use derivatives to earn risk free profit in excess of risk free rate by manipulation of mispriced securities
- Riskless profit is earned by entering into equivalent and offsetting positions in markets
- Opportunities do not last long since supply and demand will quickly eliminate the arbitrage situation
- Traders use to speculative instead of hedging the derivatives (Operational Risk)
- Loses suffered using hedging, speculation, arbitrage is high
- Control mechanism needed to monitor risk that arises out of hedging, speculation, arbitrage opportunities
- Derivatives
- Market Maker
- Spot, Forward, Future contract
- Call, Put option
- American, European option
- Long, Short position
- Exercise (strike) price
- Expiration(Maturity) date
- Bid, Offer price
- Bid-Offer spread
- Hedgers, Speculators, Arbitrageurs
- Derives its value from underlying security value
- Ex: Options, Forward, futures contract
- Individual who acts as a middleman between exchange and end user
- Buys and sells security
- Charges fees based on the services offered
- Agreement to buy/sell asset today
- No legal binding agreement in the contract
- Contract to buy/sell asset at a predetermined prices and at predetermined date in the future
- No legally binding agreement in the contract
- Legally binding agreement to buy/sell asset at a predetermined price at a predetermined date in the future
- Ex: Buy/Sell of commodities in the future like jet fuel
- Buy a specified number of shares of an underlying security on/or before the expiration date at a given strike price
- Used for hedging, speculative, arbitrage purposes
- Sell a specified number of shares of an underlying security on/or before the expiration date at a given strike price
- Used for hedging, speculative, arbitrage purposes
- Similar to call/put option except that the option can be exercised anytime between issue date and expiration date
- Valuable at times when right to exercise early will bring in profit
- Similar to call/put option except that the option can be exercised only at expiration date
- Valuable when right to exercise early doesn’t bring in any profit
- Individual who has long positions owns/buys the security in the near future
- Investor who owns long position anticipates increase in the value of the security in the near future
- Individual who has short positions sells the security in the near future
- Investor who owns short position anticipates decrease in the value of the security in the near future
- Price at which the underlying security may be bought/sold
- Date at which the option may be exercised (bought/sold)
- Price at which the buyer is willing to pay for the security
- Price at which the seller is willing to sell the security
- Use forward, futures, option to reduce their risk of the financial security that they have
- Usage of forward contracts, the hedgers neutralizes risk by paying the price of the underlying security
- Usage of options is used as an insurance policy
- Highly standardized contract specified by exchange
- The person who buys/sells futures contract is obligated to buy/sell the assets at agreed upon time and at agreed upon price
- Futures contract is used by speculators who take advantage of price fluctuations of the underlying asset to get a profit
- Futures contract is used by hedgers to reduce the risk of the underlying asset
- Price quotation
- Contract Size
- Quality of asset
- Delivery Time
- Delivery Location
- Position Limits
- Daily Price Limits
| Properties | Over the Counter Market | Traditional Exchange |
| Definition | Uses telephone and computers to make trade | Uses shouting and hand signals to make trade |
| Size | Bigger than traditional exchange | Smaller than OTC market |
| Terms of contract | Not specified by exchange | Specified by exchange |
| Can participant negotiate contract | Yes | No |
| Any type of risk involved | Credit Risk | No Credit Risk |
| How issues are resolved | Calls are recorded during transactions which serves as a reference in any disputes | Issues are resolved based on contractual terms agreed during trading |
| Properties | Forward Contracts | Options |
| Purpose | Eliminate or reduce financial exposure | Eliminate or reduce financial exposure |
| Investor with Long exposure to asset | Hedge the exposure by entering into short futures contract | Hedge the exposure by buying a put option |
| Investor with Short exposure to asset | Hedge the exposure by entering into long futures contract | Hedge the exposure by buying a call option |
| Advantages | No initial investment in executing these contracts | Initial premium to purchase options |
| Disadvantages | Hedgers give up price movements that has a positive effect in event the position is left un hedged | The price movement that has a positive effect on the options is used by the hedgers to earn a profit |
