Derivative: Arbitrageur’s Rule


The CFAI book says that " If we sell the underlying, we lend the money." How do we lend money if we are selling the underlying?


The arbitrageur abides by two fundamental rules:

  1. Rule #1 Do not use your own money.
  2. Rule #2 Do not take any price risk.

The arbitrageur often needs to borrow or lend money to satisfy Rule #1. If we buy the underlying, we borrow the money. If we sell the underlying, we lend the money. These transactions will synthetically create the identical cash flows to a particular forward commitment, but they will be opposite and, therefore, offsetting, which satisfies Rule #2. Note that for Rule #2, the concern is only market price risk related to the underlying and the derivatives used, as explained in detail later.



When we sell it we get cash. We use that cash to buy a risk-free bond.