rates may move, the arbitrage-free pricing approach is more realistic than using only one discount rate. Investors can use this approach to value bonds and find price mismatches, resulting in an arbitrage opportunity. If a bond valued with the arbitrage-free pricing approach turns out to be priced higher in the market, an investor could have such an opportunity: Investor shorts the bond at price at time t1. Investor longs the zero-coupon bonds making up the related yield curve and strips and sells any coupon payments at t1. As t>t1, the price spread between the prices will decrease. At maturity, the prices will converge and be equal. Investor exits both the long and short positions, realising a profit. If the outcome from the valuation were the reverse case, the opposite positions would be taken in the bonds. This arbitrage opportunity comes from the assumption that the prices of bonds with the same properties will converge upon maturity. This can be explained through market efficiency, which states that arbitrage opportunities will eventually be discovered and corrected. The prices of the bonds in t1 move closer together to finally become the same at tT. Conditions for arbitrage Arbitrage may take place when: the same asset does not trade at the same price on all markets ("the law of one price"). two assets with identical cash flows do not trade at the same price. 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 has significant costs of storage; so this condition holds true for something like grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change in one market before both transactions are complete. In practical terms, this is generally possible only with securities and financial products that can be traded electronically, and even then, when each leg of the trade is executed, the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'. In the simplest example, any good sold in