August 2011
Beginner
208 pages
5h 12m
English
book
Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies
by Anatoly B. Schmidt
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CHAPTER 11
Arbitrage Trading Strategies
According to the Law of One Price, equivalent assets (i.e., assets with the same payoff) must have the same price (see, e.g., Bodie & Merton 1998). In competitive markets, the price of an asset must be the same worldwide providing that it is expressed in the same currency, and the transportation and transaction costs can be neglected. Violation of the Law of One Price leads to arbitrage, which is risk-free profiteering by buying an asset in a cheaper market and immediately selling it in a more expensive market.
In FX, a typical example of arbitrage is so-called triangle arbitrage. It appears in case of imbalance among three related currency pairs. Namely, exchange rates for three currencies X, Y, and Z generally satisfy the condition
An arbitrage opportunity appears if (11.1) is violated. For example, if the product (EUR/JPY)*(USD/EUR) is smaller than USD/JPY, one can buy JPY with USD, then buy EUR with JPY, and finally, make profits by buying USD for EUR.1
Arbitrage can continue only for a limited time until mispricing is eliminated due to increased demand and finite supply of a cheaper asset.2 Such a clear-cut (deterministic) opportunity, which guarantees a riskless gain, is sometimes called pure arbitrage (Bondarenko 2003). Deterministic arbitrage should be discerned from statistical arbitrage, which is based on statistical deviations of ...
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I'm always learning. So when I got on to O'Reilly, I was like a kid in a candy store. There are playlists. There are answers. There's on-demand training. It's worth its weight in gold, in terms of what it allows me to do.