AC948 Case Studies in Financial Environments Lecture 3

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AC948 Case Studies in Financial Environments
Lecture 3

• Yuval Millo, AFM, U. of Essex

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Arbitrage in financial theory

• The importance of arbitrage the engine behind
  market efficiency
• Assumption arbitrage is done by many agents,
  each one incapable of affecting the price

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Arbitrage in real life

• Markets show that
• a small number of sophisticated agents perform
  arbitrage
• Skill and capital are distributed
• As a result
• Informational discrepancies may evolve between
  the investors and arbitrageurs and liquidity
  constrains may follow (remember the 1987
  example?)

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Performance based arbitrage

• Investors assume future returns and allocate
  capital on the basis of past performance
• Hence, capital for arbitrage, and market share,
  is a function of past performance

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Seeing the market differently

• Convergence arbitrage positions become more
  lucrative as spreads grow
• Yet, this, for the investors, is an signal for
  possible losses.
• Distributed agency in arbitrage operations
  includes a potential self-defeating element.

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Which markets have much PBA?

• Future value calculations are feasible bond
  markets, not stock markets
• What about volatility?
• Under which market conditions will high
  volatility be beneficial to PB arbitrageurs?

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Summary of the case so far

• JM left Solomons (proprietary arbitrage) and
  founded LTCM (arbitrage for investors)
• Informational gap was embedded into LTCMs
  structure
• Investors did not know about the trading
  technique
• Connection between trades and profits was unclear

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Bond markets and arbitrage

• The relation between the price and the yield make
  bond trading a relative speciality
• Cognitively
• Organisationally
• Good conditions for the development of a split
  between investors and arbitrageurs (what happened
  in Solomons?)

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Efficient markets and arbitrage

• According to the B-S model, markets followed a
  random walk.
• Yet, traders saw the model differently the model
  did not describe the market, but instead was used
  as an aid in deciding how to trade.
• So, arbitrage was performed with the model, but
  not through the models

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conditions for profitable arbitrage trading 1

• Currency futures example (p.60 Inventing Money)
• What are the conditions necessary for successful
  completion of the transaction?
• What can go wrong?

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conditions for profitable arbitrage trading 2

• Capital is necessary for
• Covering transaction costs in the time between
  opening the position and unwinding it (margin
  calls, mark to market
• Creating leverage
• Where is the risk, then?
• In the market
• In the arbitrage operation