32 CHAPTER 1. BACKGROUND IDEAS
1.4 Arbitrage
Rating
Student: contains scenes of mild algebra or calculus that may require guid-
ance.
Section Starter Question
It’s the day of the big game. You know that your rich neighborreallywants
to buy tickets, in fact you know he’s willing to pay $50 a ticket. While on
campus, you see a hand lettered sign offering “two general-admission tickets
at $25 each, inquire immediately at the mathematics department”. You have
your phone with you, what should you do? Discuss whether this is a frequent
occurrence, and why or why not? Is this market efficient? Is there any risk
in this market?
Key Concepts
- Anarbitrage opportunityis a circumstance where the simultaneous pur-
chase and sale of related securities is guaranteed to produce a riskless
profit. Arbitrage opportunities should be rare, but in a world-wide
market they can occur. - Prices change as the investors move to take advantage of such an op-
portunity. As a consequence, the arbitrage opportunity disappears.
This becomes an economic principle: in an efficient market there are
no arbitrage opportunities. - The basis ofarbitrage pricingis that any two investments with identical
payout streams must have the same price.
Vocabulary
- Arbitrageis locking in a riskless profit by simultaneously entering into
transactions in two or more markets, exploiting mismatches in pricing.