To arbitrage, an arbitrager must find a perfect substitute or there is market risk. how does it work, can someone plesae explain??
if you notice a mispricing with say with car company A and to take advantage of the mispricing you have to go long the stock you are exposed to market risk. in order to eliminate this market risk you would go short a perfectly correlated subsititue (car company b). therefore, anything that effects the market risk of the car companies will offset each other (A rises, B falls) leaving the only exposure of your position being the arbitrage you are exploiting.
In practice there are few perfect substitutes. I read somewhere (not in CFA curriculum, but maybe it’s burried there too), that you can think of a true arbitrage as a profit you can achieve with no net cash outlay (like covered interest rate arbitrage), or getting a loan you never have to pay back (like selling overpriced options). I’ve been wanting to finish that book “Understanding Arbitrage” because I wanted to get a better feel for spotting arbitrage opportunities when they exist. For example, figuring out that a call option can be arbitraged by a portfolio of delta*underlying is really interesting, but I’d never in a million years (well, maybe a million) come up with that idea on my own.