CFA Level 1 - Derivatives
Additional information about arbitrage and its theories:
- Theoretically, the large number of market participants combined with real-time price-setting mechanisms eliminates the opportunity to generate risk-free profits.
- This leads to an important question: If there are no arbitrage opportunities (i.e. opportunities to earn a risk-free profit), why does the industry survive? One reason is that individual investors may have different views on how, why and to what degree market prices are off kilter. Also, investors are reluctant to believe that there are no arbitrage opportunities and so they spend a good deal of time watching price movements, ferreting out inconsistencies and trading on those they perceive to exist. The process itself ensures that any potential arbitrage opportunities will be quickly discovered and eliminated. If investors believed there were no arbitrage opportunities and were no longer vigilant about identifying and exploiting price differentials, the lack of continuous oversight might, in itself, lead to arbitrage opportunities In other words, disbelief concerning the absence of arbitrage opportunities is required to maintain its legitimacy as a principle.
- Relatively efficient markets have either no arbitrage opportunities or the market participants quickly remove them. The opportunity can occur, but only through chance and it would be considered an abnormal return