The Nature and Significance of Arbitrage
Arbitrage is the process of earning a riskless profit by taking advantage of different prices for the same good, whether priced alone or in equivalent combinations. Thus, due to mispricing, a riskless position is expected to earn more than the risk-free return. A true arbitrage opportunity exists when simultaneous positions can be taken in assets that earn a net positive return without exposing the investor to risk and, importantly, without requiring a net cash outlay. In other words, pure arbitrage requires no upfront investment but nonetheless offers a possible profit. The requirement that arbitrage not demand additional funds allows for the possibility that the position either generates an initial cash inflow or neither provides nor requires any cash initially. Consider the intuition behind this requirement. A positive initial outlay means that the arbitrage strategy is not self-financing. This would imply at least the risk that the initial investment could be lost, which is inconsistent with the no-risk requirement for the presence of an arbitrage opportunity.10
Arbitrage may be considered from at least two perspectives. First, arbitrage may involve the construction of a new riskless position or portfolio designed to exploit a mispriced asset or portfolio of assets. Second, arbitrage may involve the riskless modification of an existing asset or portfolio that requires no additional funds to exploit some mispricing. Both perspectives are considered in the arbitrage examples presented in Chapter 2, "Arbitrage in Action."
The Relationship Between the Law of One Price and Arbitrage
If the Law of One Price defines the resting place for an asset’s price, arbitrage is the action that draws prices to that spot. The absence of arbitrage opportunities is consistent with equilibrium prices, wherein supply and demand are equal. Conversely, the presence of an arbitrage opportunity implies disequilibrium, in which assets are mispriced. Thus, arbitrage-free prices are expected to be the norm in efficient financial markets. The act of arbitraging mispriced assets should return prices to their appropriate values. This is because investors’ purchases of the cheaper asset will increase the price, while sales of the overpriced asset will cause its price to decrease. Arbitrage consequently reinforces the Law of One Price and imposes order on asset prices.