Lecture 11 –Trading Strategies and Algorithmic Trading

Arbitrage:

·         Theoretically, when prices do not reflect fundamentals, arbitrage provides the mechanism by which any pricing discrepancies are quickly eliminated

·         In practice, arbitrage refers to the profit generating mechanism on prices that temporarily deviate from the theoretical or perceived equilibrium relationship

 

Categories of Arbitrage:

·         Pure arbitrage

·         Near arbitrage

·         Speculative arbitrage

 

Conditions for Arbitrage:

·         The possibility of arbitrage can only occur when one of three conditions are met:

o   The law of one price does not hold (i.e., the same asset does not trade at the same price on all markets)

o   Two assets with identical cash flows do not trade at the same price

An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities
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