no arbitrage condition

CFA Level II
#1

can someone help me understand better what we mean when we say

no arbitrage condition

or

bound by arbitrage?

Thanks

#2

They mean that the price is constructed so that there is no opportunity for an arbitrage transaction.

For example, the price of a Treasury bond has to equal the sum of the prices of the constituent Treasury strips; if their prices were different, there would be an arbitrage opportunity. The no-arbitrage condition manifests itself in the relationship between the par curve (used to price the bond) and the spot curve (used to price the strips).

Another example is the price of a currency forward contract. The no-arbitrage condition manifests itself in the relationship between the spot exchange rate and the forward exchange rate: it has to conform to interest rate parity. If the price were anything else, there would be an arbitrage opportunity.

#3

Theyin-yang symbol represents the no arbitrage condition. Black and white are equally priced assets. You can buy black, sell white and make zero profit. Or you can unsell black and unbuy white with the same effect. You can make an agreement to buy black and sell white in the future. Doesn’t matter. The key is that they are both bound by the circle that outlines the symbol. This circle represents the arbitrage relationship. If black increases in size, that pushes white into black and balance is again restored.

Now imagine there is no circle: black or white can grow disproportionately bigger and their net effect will not be zero. If you entered in an agreement for future settlement this can work either in your favor or against you. Since you don’t know which one will grow bigger you have no guaranteed outcome, whereas with the circle you can rest assured that any increase will be offset proportionately.

Circle=covered IRP

No circle= uncovered IRP.