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:
- Rule #1 Do not use your own money.
- 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.