94dd9e62_casts__Investment_Philosophies__Outline
[Session] 27 [Book chapter] 11 [Downloads] Webcast Slides Post-class test [Outline] 
Too good to be true? Pure Arbitrage In this session, we lay down the requirements for pure arbitrage: assets that have identical cash flows that trade at different prices at the same point in time in different markets, with a guarantee that that the price difference will close. We note that pure arbitrage is most likely to occur in the derivatives markets and establish the arbitrage relationships that should govern the pricing of futures and options. With futures on storable commodities and financial assets, we create positions that have the same cash flows and risk using the futures and the underlying assets, and argue that if these positions have different costs, arbitrage is possible. With options, we introduce the notion of a replicating portfolio, where combining the underlying asset with borrowing/lending can create the same cash flows as an option, and argue that arbitrage is possible if the option and the replicating portfolio trade at different prices. We also look at arbitrage across options (calls and puts, options with different strike prices). With both futures and options, we conclude that arbitrage opportunities seem to exist in the early years after a new derivative is listed but fade as investors learn how to price the derivative.
Webcasts: Investment Philosophies
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