What Is the Significance for Financial Economics of the Concept of Arbitrage - Assignment Example

What Is the Significance for Financial Economics of the Concept of Arbitrage? Table of Contents S.No Heading Page No Introduction 3 2 Analysis 4 3 2.1 Different Kinds of Arbitrages 4 2.2 “How Arbitrage is employed in Share Trading as Risk Arbitrage?” 5 2.3 How Arbitrage Works in the Gold Trading under the Law of One Price 7 3 Conclusion 9 4 List of References 11 1. Introduction Arbitrage is to identify mispricing and to establish stratagems to exploit it. Arbitrage is nothing but the act of exploring various prices for the same portfolio or asset. As per Stephen A Ross, one can make even a parrot as a knowledgeable political economist , but all it must has to comprehend are the just two words : “demand” and “supply” (Ross 1976:341). To change a parrot as a knowledgeable financial economist is to make it to learn the sole word “arbitrage”. Arbitrage can be explained as the “process of procurement of assets in one market and disposing it off in another market to gain profit from unjustifiable differences in prices”. (Ross 1976:341). It is to be noted that arbitrage is not only riskless but also remains as self-financing, which implies that the investor uses somebody’s money (Ross 1976:341). The neoclassical theory of finance is footed upon the study of a) efficient markets , which means the markets that employ all available data in fixing price , b) the trade-off between risk and return , c) the principle of no arbitrage and option pricing ,d)corporate fianance that is , the organisation of financial claims made by corporates. (Ross 2008). As per Ross, neoclassical equilibrium efficiency connotes to Pareto efficiency, which means that there is no way available to enhance the well being of any one individual without making someone worse off. If a capital market is efficient and competitve , then neoclassical reasoning suggests that the return that an investor anticipates to receive on an investment will be equivalent to the opportunity cost of employing the funds. Thus , investing on a risky asset should offer some extra return as compared to riskless investment. The Arbitrage Pricing Theory (APT) Model assumes that an asset’s anticipated return is impacted by a variety of risk factors, as contrasted to just market risk as adopted by the CAPM. The APT model expresses that the return on a security is linearly associated to H systematic risk elements. Nonetheless, the APT model does not indicate what the systematic risk elements are, but it is presumed that the relationship between the risk factors and asset returns is linear (Focardi & Fabozzi 2004:88). This research essay tries to analyse the significance of arbitrage to financial economy in an exhaustive manner. 2. Analysis Investors are more concerned with whether a financial asset value or price is either fair or correct. They evaluate for striking characteristics or conditions in an asset connected with misvaluation. For instance, evidence exists that some low P/E (price earnings) stocks are reactive to bargains and hence, investors cautiously approach for this characteristic along with the other indicators of value. Further, the absence of an arbitrage opportunity is at least as vital as its existence. While the existence of arbitrage opportunity indicates that a risk-free strategy can be perused to generate a revenue in case where there exists higher risk-free rate, and its absence points out that an asset’s price is at rest (Randall & Billingsley 2005:7). 2.1 Different Kinds of Arbitrages There are different kinds of arbitrage and each of them is defined as follows: Tax arbitrage – it transfers revenues from one investment tax group to another to avail the benefit of varied tax rates across income groups. Risk arbitrage- it is a commonly employed process of simultaneous purchasing of an acquisition target’s stock and disposing off the buyer’s stock. Pairs trading – it refers to the two stocks whose prices have changed closely in the past. If the particular price spread enlarged not normally, then, those stocks with the lower price are purchased and those stocks with higher prices are disposed of short. Regulatory Arbitrage – this denotes the inclination of the firms to shift towards a least-restrictive regulator- banks trying to utilize the arbitrary regulatory variances to their favour. Index arbitrage- this pertains to offsetting of short and long positions in a stock index futures’ contract and an imitating cash market portfolio when the price of the futures varies strikingly from its theoretical value (Randall & Billingsley, 2005, p.3). 2.2 “How Arbitrage is employed in Share Trading as Risk Arbitrage?” The secret of Warren’s Buffett success in investment in shares can be attributed to arbitrage as he will be considering to make investment only after the merger or acquisition deal is announced and made public. Thus, to comprehend the whole gambit of risk arbitrage where money managers spend a lot of time on watching which companies will be acquired or taken over in the near future so that they can invest in them well before public announcement of the same. Thus, an investor can make a huge profit in a short period of time if one has the foresight to invest in the right company well ahead of any public announcement about the takeover. For instance, Berkshire Hathaway made a public announcement that it would be buying BNSF shares at $100 per share while the shares of BNSF were traded at $76 per share at the time Berkshire public announcement. Reacting to the news, the share price jumped to $97 from that of earlier trading at $76 per share. If an investor had bought the huge volume of shares of BNSF, he would have booked a profit of $21 per share, which was equivalent to the ROI of 27% per on the investment. This is really a windfall profit as the investor should be either gifted with the foresight or lucky to have such kind of profit. In the above instance, Warren would not have invested on hearing gossips, and he might be interested in investing at $97 when announcement was made, and he would have been satisfied with a gain of $3 per share. ($100-$97). Though profit might be seen as negligible but certainty of deal would have allowed him to earn some certain and quick return as there had been the chances of employing higher quantum of leverage to more than 300% of his initial rate of return as compared to his real out-of- pocket cost. Thus, Warren Buffett, it is the certainty of the transaction that permits him to have a comfortable leveraging up on the transaction (Buffett & Clark 2011:4). Arbitrage offers both carrot and stick in an efficient functioning financial market. Hedging is closely associated with the arbitrage which is a stratagem which eliminates or minimizes risk and probably results in gains or profit. Though, all the arbitrage strategies bank upon hedging to make a position risk-free, but, not all the hedging results in arbitrage. Pure arbitrage is one, which is riskless in pursuit of gains deriving from mispriced assets. On the contrary, hedging is attempting to minimise, if not to remove, risk, but not necessarily involve any mispriced assets. Hence, hedging does to track or purse gains or profits (Randall & Billingsley, 2005, p.3). Arbitrage involves investment in many types of securities. If an arbitrageur invests in ordinary stocks of companies associated in takeover or merger transaction and if shares of acquiring company is being allotted to shareholders of Target Company, then, the arbitrageur will also dispose of short an analogues amount of the issuer’s shares, mainly to safeguard or hedge against market risk associated with the above transactions. It is to be noted that common stock is the only type of security associated in the arbitrageur’s evaluation and investment process. Options, bonds and convertible securities will also be assessed to decide whether they bestow the arbitrageur a best choice of investment. Once an arbitrageur has decided how to establish a position, put and call options will also be employed as an arbitrage process. While establishing the arbitrage position in the overall portfolio, the arbitrageur is normally attempting to benefit from the spread between the price of the securities covered under the transactions and the takeover price or deal value. The discount or spread from the deal value will be present for two reasons a) the risk premium and b) the time value. The arbitrageur’s aggregate portfolio management strategy must involve various risk disciplines and parameters to guarantee the capacity to face individual deal losses or aggregate general equity market, which shifts over different investment cycles. Excepting the debacles during past financial crisis, risk arbitrage can offer investors with a profitable strategy to enhance revenues that will not be reliant upon equity market moves (Moore 199:10). 2.3 How Arbitrage Works in the Gold Trading under the Law of One Price The Law of One Price (LOP) operates in a competitive market, if two assets are analogues, they will tend to remain equivalent market price. The LOP is implemented by a process namely arbitrage , the buying and selling of analogues assets so as to pocket a quick profit due to variance in their prices. For instance, if the price of the gold in New York is quoted as $1000 per ounce and in Minneapolis, if the same is quoted as $950 per ounce, if the shipping, handling, broker and insurance costs about $25 per ounce, then, an investor can be able to gain $25 per ounce by buying it in Minneapolis and selling the same in New York. To eliminate the risk in price differences, the seller can lock the selling price in NY and at the same time, he can delay the payment in Minneapolis till he receives the sale money in NY. The arbitrageurs and the gold dealers will buy gold in Minneapolis and sell it in NY as long as the transaction cost is less than the narrow price band of gold between these places (Bodie 2008:228). Arbitrage-Free Condition Figure 1. Arbitrage Diagram for the Marginal Market Source: (Ellerman 2000) 2.4 Arrow Security Prices and Risk- Neutral Probabilities The term Arrow Securities is named after the Laureate Kenneth, an economic noble prize winner who first explained the use of such securities in his research paper published in 1953. Arrow Securities are footed upon the basic building block of all contingent claims like derivatives, whose payoffs may be based upon happening of a future event. An arrow security is explained as a security that pays $1 that is reliant upon happening of an event and will pay nothing if that event does not happen at all. Thus, let us assume that one of the arrow security is ready to pay $1 at a day T if the up state happens and other arrow security will pay $1 at a day T if the down state happens. For instance, the stock is equivalent to a portfolio comprising of Su units of the first arrow securities and Sd units of the second arrow security, as the stock is valued at Su dollars in the up condition and Sd dollars in the down condition. Equation “(1.5a) – (1.5c) “depict that πu is the price for the first Arrow Security Πd is the price for the second Arrow security. For instance,” the right-hand side of (1.5b)” is the value of stock at date 0 regarded as a portfolio of Arrow securities when the Arrow securities quoted at the prices of πu and πd. Thus, πu and πd of the Arrow securities are known as the “state prices” since they are the prices of receiving $1 in the two stipulated conditions state. The state prices have to be positive as the payoff of each Arrow security is non-negative in both conditions and is remaining as positive in one condition. πu > 0 and πd > 0 are precisely analogues to “no-arbitrage assumption”. Thus, one can arrive at a conclusion that in the absence of arbitrage chances, there remain positive state prices such that the price of any security is the aggregate of the conditions’ of the state of its payoff multiplied by the state price (Back 2000:13). r[c] = (1/2) (1/3)(3/2)(4/3)(1/4)(12) = 1 Figure 2. An Arbitrage-Free Market Graph Source: (Ellerman 2000) 3-Conclusion For corporate finance , the neoclassical theory is now well founded. However , there is the inadequacy of the neoclassical analysis which driving researchers to start to challenge but to indulge in exploring of theories of asymmetric information. Due to existence of anamolies in capital markets , explaining the financial funciton has eluded the neoclassical theory. The constant interplay between empirical analysis and theory of finance which really differentiates finance from the rest of the economics. The test of these new strategms will be decided less by reference to their aesthetics and more by their practicality in defining financial data . In the near future , both theory and empirical analysis will become one element. Arbitrage is the process of procurement of assets in one market and disposing it off in another market to gain profit from unjustifiable differences in prices. Thus, an investor can make a huge profit in a short period of time if one has the foresight to invest in the right company well ahead of any public announcement about the takeover. For Warren Buffett, it is the certainty of the transaction that permits him to have a comfortable leveraging upon the transaction. Thus, all the arbitrage strategies bank upon hedging to make a position risk-free, but not all the hedging results in arbitrage. List of References Kerry Back (2006) A Course in Derivative Securities. Introduction to Theory and Computation New York: Springer Science and Business Media; p.13 Bodie (2008) Financial Economics New Delhi: Pearson Education India;p.228 Mary Buffett & David Clark (2011) Warren Buffett and the Art of Stock Arbitrage New York: Simon & Schuster;p.4 David Ellerman (2000) Towards an Arbitrage Interpretation of Optimization Theory New York : World Bank Publications Sergio M Focardi & Frank J Fabozzi, FJ.(2004). The Mathematics of Financial Modelling and Investment . New York : John Wiley & Sons;p.88 Keith M Moore (1999) Risk Arbitrage: An Investor’s Guide. New York: John Wiley & Sons ; p.10 Billingsley Randall & Randall S Billingsley (2005) Understanding Arbitrage: An intuitive Approach to Financial Analysis. New Delhi: Pearson Education India;p.7 Stephen A Ross (1976) The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory 13(3) 341-360. Read More