Arbitrage profit

This demonstrates that the only situation in which no arbitrage profit can be made is when P t,T) = (For texts providing more detail on... 

FIGURE 16.7 on the following page shows the present values of the Treasury s cash flows, each discounted using the relevant market interest rate, and the present values of the strip cash flows, each discounted using the observed market yield corresponding to its maturity. A comparison of the two sets reveals an opportunity for arbitrage profit. 

The fair price of a convertible bond is the one that provides no opportunity for arbitrage profit that is, it precludes a trading strategy of running simultaneous but opposite positions in the convertible and the underlying equity in order to realize a profit. Under this approach we consider now an application of the binomial model to value a convertible security. Following the usual conditions of an option pricing model such as Black-Scholes (1973) or Cox-Ross-Rubinstein (1979), we assume no dividend payments, no transaction costs, a risk-free interest rate, and no bid-offer spreads. 

The profitability of an arbitrage-driven CDO depends on such factors as the following ... 

The result of this calculation, 0.06, is the arbitrage-free price of the option if the option were priced below this, a market participant could earn a guaranteed profit by buying it and simultaneously selling short the replicating portfolio if it were priced above this, a trader could profit by writing the option and buying the portfolio. Note that... 

Market makers who strip Treasuries earn their profits through arbitrage that exploits the mispricing of the coupon bond. To preclude arbitrage opportunities, the bid price of an issued Treasury must be lower than the offer price of a synthetic one—that is, one reconstituted from a bundle of coupon and principal strips—and the Treasury s offer must be higher than the synthetic s... 

One compromise to the dilemma would be the possibility that the high-precision retailer would find an arbitrage opportunity from the discrepancy between the current market price (in disequilibrium) and his accurate assessment, and trade to make profits. It will expedite the equilibrating process, and efficiency may be regained. This is admittedly a temporary fix for an important issue, and further investigation is called for. We leave it for future research. 

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