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 discr epancies are quickly eliminated • In practice, arbitrage refers to the profit generating mechanism on prices that temporarily deviate from the theoretical or per ceived 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 certaint y at a given time in the future o E.g. Stock splits and mergers ▪ In either case, the time frame for convergence is obvio us as it is the conversion date • Absolute convergence: o The value of an asset is known with cer tainty 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 prov ides the convergence FINC3014 – Trading and Dealing in Security Markets 3 time frame • Hypothetical C onvergence: o Relies on identifying long r un relationships between assets o Where their prices have temporarily diverged, profita ble trading opportunities exist o By buying (selling) the asset whose value has fallen (risen) relative to the long run equilib rium 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)?