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Chapter 11. A Sure Thing: No Risk and Su... > Theoretical Roots of Arbitrage

Theoretical Roots of Arbitrage

To understand arbitrage, you begin by distinguishing between three types of arbitrage:

  • Pure arbitrage: Two identical assets have different market prices at the same time, but those prices will converge at a given future time. This type of arbitrage is most likely to occur in derivatives markets—options and futures—and in some parts of the bond market.

  • Near arbitrage: Assets have identical or almost identical cash flows but trade at different prices, with no guarantee that their prices will converge and with significant constraints on investors forcing them to do so.

  • Speculative arbitrage: This is really not arbitrage. Investors take advantage of what they see as mispriced or similar (though not identical) assets, buying the cheaper one and selling the more expensive one. If the investors are right, the price difference should narrow over time, yielding profits. As you will see, the peril of this strategy is the initial assessment of mispricing is usually based on a view of the world that may not be justified.


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