Arbitrage and its role in market efficiency and price determination

Arbitrage is risk-less profit. In an arbitrage opportunity, the trader makes a profit greater than the risk-free rate. One can earn risk-free rate without taking any risk, but that will not be considered as arbitrage.

To understand the arbitrage, the elementary principles of derivative pricing needs to be understood. The pricing depends on the storage costs and the benefits. The greater is the cost; the higher will be the price and vice versa. The presence of benefits decreases the price of the derivative instruments. These things are discussed in detail in the next chapter.

Arbitrage helps in determining prices and improving the market efficiency because the presence of arbitrageurs forces the price to converge. The arbitrage is often referred to as the law of one price i.e. two similar assets should trade at the same price or the combination of different instruments having the similar cash flows should trade at the same price.

The arbitrage examples will be discussed in detail in the next reading.

Check your concepts:

(57.10) Which of the following is least likely to be a result of arbitrage?

(a) More efficient markets
(b) Law of one price
(c) Earning a return in excess of return appropriate for the assumed risk

Solutions:

(57.10) Correct Answer is A: Arbitrage results in more efficient markets and it forces equivalent assets to have a single price. Earning a return in excess of return appropriate for the assumed risk is known as abnormal return and it has nothing to do with the arbitrage. Arbitrage results in riskless profit with no capital requirement.

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