Borrow arbitrage profit - Derivatives

Why do we borrow the present value of arbitrage profit at t=0? Aren’t we removing the arbitrage profit this way that we gained at the end of say t=1?

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One of the basic characteristics of arbitrage is that you make cash profit now and don’t have to do any repayments later (i.e. the FV of all other instruments net one another, so you get zero cash outflows in the future). You could theoretically not borrow the PV of the profit now and collect its FV later instead, but such a transaction would not be defined as arbitrage (or rather it could be viewed as arbitrage plus lending at the risk-free rate at the same time).

Nenorr wrote:

One of the basic characteristics of arbitrage is that you make cash profit now.

How can you make cash profit now when there is a futures contract in which we have to transact in the future.

Nenorr wrote:

You could theoretically not borrow the PV of the profit now and collect its FV later instead, but such a transaction would not be defined as arbitrage (or rather it could be viewed as arbitrage plus lending at the risk-free rate at the same time).

But why would we want the PV of arbitrage profit now when the arbitrage is happening later and why isn’t collecting FV later an arbitrage? And what do you mean by ‘it can be viewed as arbitrage plus lending at the risk-free rate ’ please explain this

Nenorr wrote:
One of the basic characteristics of arbitrage is that you make cash profit now … .

Arbitrage simply means a profit without risk; you needn’t get all of the cash now.

Simplify the complicated side; don't complify the simplicated side.

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S2000magician,

thank you - I have a little tough time understanding this as well.  To quote the CFAI “suppose that in setting up the transaction, you know that it will produce an arbitrage profit of €5.  Then you could borrow the present value of €5 and pay it back at expiration with the arbitrage profit.”

pg. 313

If I borrow PV €5 and then pay back FV €5 would that net to zero? What is the point of borrowing the arbitrage profit.

I can quite get my head around this however I’m close just need a little guidance.

oakwood42 wrote:

S2000magician,

thank you - I have a little tough time understanding this as well.  To quote the CFAI “suppose that in setting up the transaction, you know that it will produce an arbitrage profit of €5.  Then you could borrow the present value of €5 and pay it back at expiration with the arbitrage profit.”

pg. 313

If I borrow PV €5 and then pay back FV €5 would that net to zero? What is the point of borrowing the arbitrage profit.

I can quite get my head around this however I’m close just need a little guidance.

Time 0 - inflow equal to loan amount from bank €5 (this is the future arbitrage profit).  Now I can walk around town with my profit today.

Time T - In the future the contract expires and I net €5 profit

Time T - since I am responsible borrower I pay back the loan €5

Net cash flow at Time T = €0

oakwood42 wrote:
S2000magician,

thank you - I have a little tough time understanding this as well.  To quote the CFAI “suppose that in setting up the transaction, you know that it will produce an arbitrage profit of €5.  Then you could borrow the present value of €5 and pay it back at expiration with the arbitrage profit.”

pg. 313

If I borrow PV €5 and then pay back FV €5 would that net to zero? What is the point of borrowing the arbitrage profit.

I can quite get my head around this however I’m close just need a little guidance.

In your scenario there is no arbitrage profit.

An arbitrage profit has to exceed the risk-free rate.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

S2000magician wrote:

oakwood42 wrote:
S2000magician,

thank you - I have a little tough time understanding this as well.  To quote the CFAI “suppose that in setting up the transaction, you know that it will produce an arbitrage profit of €5.  Then you could borrow the present value of €5 and pay it back at expiration with the arbitrage profit.”

pg. 313

If I borrow PV €5 and then pay back FV €5 would that net to zero? What is the point of borrowing the arbitrage profit.

I can quite get my head around this however I’m close just need a little guidance.

In your scenario there is no arbitrage profit.

An arbitrage profit has to exceed the risk-free rate.

OK - I will keep working on it.  I think I know what you are saying. TY

Damn son already studying for this test for next year?

snfuenza wrote:

Damn son already studying for this test for next year?

lol - no comment.