Hi Brave Ones, Just a simple thought that is challenging me: Why in some forward-arbitrage exercises we “implicitly” have the money to invest and buy currency (CFAI Vol 6 p.54 exerc.12) and in other ones we have to borrow money to invest in a security (CFAI Vol 6 p.51 exerc. 5 A). In the former exercise if we did not have the money to buy currency at spot it would make all the difference regarding the exploitation of this arbitrage opportunity… How can I know when to assume that, for instance in a currency forward, that I have the money to make the initial outlay without the need of borrowing? I hope you can help…I tried my best explaining this “little” confusion… all the best for you all, tigas
Buy low, sell high. use that principal. instead of looking for whether you have the money or not…if you are doing that, you missed the principal or arbitrage, because in concept it is making money out of nothing. 5A. Current is 200, RFR=5% 3 month forward would be available at 200*(1.05)^3/12 = 202.45 it is available for delivery at 205 > 202.45. Forward available is higher priced. So Sell HIGH, BUY LOW. so borrow 200, buy the spot (200) sell the currency forward. once you do that - you get 205 in the forward market, pay off your 202.45 (borrow + interest) and make a profit of 2.55$ use the same principal on 12 and see if it makes sense.
tigas Wrote: ------------------------------------------------------- > > How can I know when to assume that, for instance > in a currency forward, that I have the money to > make the initial outlay without the need of > borrowing? > you will always have to borrow, unless the arbitrage strategy involves selling the security at spot - in which case the gains from the sale will be invested at the risk free rate.
Borrow and you pay interest. Do not borrow and you pay opportunity costs. The price of the capital invested is the same either way
thank you all, for real! I’m struggling to finish derivatives+pm exercises and jump to samples, “mixed” q-bank and all the other stuff. tigas
From what I can recall in the readings, the idea of arbitrage is to create a riskless profit without putting any of your own capital at risk. This can be achieved by borrowing the funds or shorting an asset to pay for a long position. Sincerely, Brave One