FINC3014 � Trading and Dealing in Security Markets

Name: FINC3014 � Trading and Dealing in Security Markets
Brand: University of Sydney
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Author: Layla Cooper

Discusses trading and dealing in financial security markets.

Layla Cooper

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FINC3014 – Trading and Dealing in Security Markets
1
FINC3014 – Trading and Dealing in Security Markets
Explain the concept of arbitrage in trading strategies, focusing on the three
categories of arbitrage: pure arbitrage, near arbitrage, and speculative arbitrage.
Use examples from financial markets, such as futures or stock index arbitrage, to
illustrate each type. Additionally, discuss the risks involved in arbitrage strategies,
particularly execution and timing risks.
Word count requirement: 800-1,000 words.

FINC3014 – Trading and Dealing in Security Markets
2
Lecture 11 –Trading Strategies and Algorithmic Trading
1. EQUITIES ARBITRAGE / TRADING STRATEGIES:
Arbitrage:
• Theoretically, when prices do not reflect fundamentals, arbitrage
provides the mechanism by which any pricing discrepancies are quickly
eliminated
• In practice, arbitrage refers to the profit generating mechanism on prices
that temporarily deviate from the theoretical or perceived equilibrium
relationship
Categories of Arbitrage:
• Pure arbitrage
• Near arbitrage
• Speculative arbitrage
Conditions for Arbitrage:
• The possibility of arbitrage can only occur when one of three conditions
are met:
o The law of one price does not hold (i.e., the same asset does not
trade at the same price on all markets)
o Two assets with identical cash flows do not trade at the same price
o An asset with a known price in the future does not today trade at
its future price discounted at the risk-free interest rate (or, the
asset does not have negligible costs of storage; as such, for
example, this condition holds for grain but not for securities).
E.g. A stock is traded on both the NYSE Euronext and the London Stock Exchange
(LSE).
Suppose that the stock price is $172 in New York and ₤100 in London at a time
when the exchange rate is $1.7500 per pound.
In the absence of transactions costs, what is the arbitrage opportunity?
→ Buy in NYSE for $172, sell in London for $175
Price Convergence:
• Explicit convergence:
o The rate of exchange of one asset for another is known with
certainty at a given time in the future
o E.g. Stock splits and mergers
▪ In either case, the time frame for convergence is obvious as
it is the conversion date
• Absolute convergence:
o The value of an asset is known with certainty at a given point in
time
o E.g. Futures and options
▪ They must converge to their cash value at maturity
▪ Thus, the contract expiry date provides the convergence

FINC3014 – Trading and Dealing in Security Markets
3
time frame
• Hypothetical Convergence:
o Relies on identifying long run relationships between assets
o Where their prices have temporarily diverged, profitable trading
opportunities exist
o By buying (selling) the asset whose value has fallen (risen) relative
to the long run equilibrium value, profits can be made
Risks of Arbitrage:
• Execution risks
• Timing risks
PURE ARBITRAGE:
• For pure arbitrage, you have two assets with identical cash flows and
different market prices
• Pure arbitrage difficult to find in financial markets
Determinants of success of pure arbitrage
• Access to real-time prices
• Instantaneous execution (minimal latency)
• Access to substantial debt at risk-free rate
• Economies of scale
Markets where pure arbitrage is feasible:
• Futures markets:
• Options market
• Fixed income markets
Futures arbitrage (stock futures and stock):
• Futures contract: a contract to buy (and sell) a specified asset at a fixed
price in a future time period
What price would the investor be prepared to pay for a futures contract on an
investment asset (with no income)?
What price would the investor be prepared to pay for a futures contract on an
investment asset (with income)?

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University

University of Sydney

Subject

Finance

FINC3014 � Trading and Dealing in Security Markets

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