Handbook of Finance: Financial Markets and Instruments

Chapter 8. An Arbitrage Perspective of the Purpose and Structure of Financial Markets

ROBERT DUBIL, PhD

Associate Professor, Lecturer of Finance, David Eccles School of Business, University of Utah

Abstract: From a structural point of view, all financial markets, whether for equities, bonds, currencies, or commodities, are the same. They all have distinct primary issuers and secondary traders. They all have spot, forward, and option vehicles. They all have two types of traders—hedgers and speculators—with two different trading motives. And in all markets, the primary trading strategy driving most of activity is relative risk arbitrage, whose goal is to earn reward for taking on exposure to secondary risk factors while eliminating primary directional risks through static or dynamic hedging.

Keywords: spot markets, forward markets, contingent claims, relative-value arbitrage, pure arbitrage, speculation, hedging, risk sharing, cash-and-carry

Financial markets play a major role in allocating wealth and excess savings to productive ventures in the global economy. This extremely desirable process takes on various forms. Commercial banks solicit depositors' funds in order to lend them out to businesses that invest in manufacturing and services or to home buyers who finance new construction or redevelopment. Investment banks bring to market offerings of equity and debt from newly formed or expanding corporations. Governments issue short- and long-term bonds to finance construction of new roads, ...