Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives by Sunil K. Parameswaran

Author:Sunil K. Parameswaran [Parameswaran, Sunil]
Language: eng
Format: epub
ISBN: 9781119816638
Publisher: Wiley
Published: 2022-04-18T00:00:00+00:00

RISK ARBITRAGE

In the preceding case we stated that the futures price prior to expiration will converge to the delivery-adjusted no-arbitrage futures price of the CTD grade. For all other grades we can state that or . The issue is that if the futures price is lower than the delivery-adjusted no-arbitrage futures price for a grade, then why can we not implement a reverse cash-and-carry arbitrage strategy to earn a costless, riskless profit. The answer is that such strategies are not riskless.

Let us analyze the cash-and-carry strategy for contracts on a commodity where the additive/multiplicative price adjustment systems are used. Arbitrageurs would have gone long in the required number of units in the spot market and assumed a short position in the futures market. Since they hold the short position in futures, they have the prerogative to decide as to which grade they should choose to deliver. If the maximum profit is likely to be obtained by delivering the grade in their possession, then they will choose to deliver that grade. If, however, they were of the opinion that any other grade is likely to lead to a larger cash flow if delivered, then they would choose to dispose of the grade in their possession in the spot market and acquire the required number of units of the grade that will lead to optimal profits if delivered. Consequently, while arbitrageurs may realize the profits that they have been anticipating from the outset, they can only earn more if circumstances were to change.

Reverse cash-and-carry arbitrage, however, is different. It requires arbitrageurs to go long in futures and short in the spot. In this case the right to choose the deliverable grade is with the counterparty and not the arbitrageurs. There is no guarantee that the counterparty will choose to deliver the grade that the arbitrageur has sold short. If they choose to deliver a different grade because it is optimal for them, then the arbitrageurs will realize a lower profit than anticipated. Thus, while implementing a reverse cash-and-carry strategy, arbitrageurs may end up realizing a lower profit, which in practice may even be a loss, and can never earn more than what they were anticipating at the outset. It is for this reason that reverse cash-and-carry arbitrage under such circumstances is termed as risk arbitrage. We will now demonstrate these arguments, first with the multiplicative adjustment system, and then with the additive adjustment system.

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