What is an arbitrage?

A question from Schweser notes:

Arbitrage prevents:

a. market efficiency

b.profit higher than the riskfree rate of return

c. two assets with identical payoffs from selling at different prices.

I chose A since an efficient market is a market with no arbitrage opporunities. Yet the correct answer is C. But I would say an arbitrage opporunity ARISES when two assets with identical futures payoffs are selling at a different prices currently. One could buy the cheaper one and sell the more expensive one for an immediate profit.

Can someone clarify my confusion plz?

As people exploit the arb in the market, the arb opportunity will dissapear. So as soon as a tiny mispricing appears, it will disapear because of the arbitrage opportunity. So the market is efficient because of arbitrage, not the other way.

I think you are confusing “mispricing” with “arbitrage”. The mispricing creates the opportunity for arbitrage. And arbitrage rectifies the mispricing.

a. would make sense based on the info you provided. In an efficient market, there should be no arbitrage opportunities

Rain does not cause clouds. Clouds cause rain.

Arbitrage does not prevent market efficiency. Market efficiency prevents arbitrage.

Markets are efficient because there are arbitrage trading desks active in those markets. These trading desks prevent large mispricings from existing and allow only small mispricings to occur for a few nano seconds. But these trading desks exists and are profit generating, they just make a lot (50,000 trades a day sort of volume) of really really small profit trades.

They (Arbitrage) “prevent two assets with identical payoffs from selling at different prices”.

if price of an asset is higher somewhere and if you can find that asset at a cheaper price (including cost) you can make an arbitrage profit by buying cheap and sell high.

A is incorrect. Arb leads to greater efficiency. An S&P500 future, option, ETF and baset of equities will all trade in line due to the arb - if one steps out of line it is traded back into line because it is arbed.

B is incorrect. The min/max returns of an arb relative to the RFR is not defined.

C is mostly correct. They can trade away from each other momentarily, but not over the long term. Consider two different S&P500 ETFs. If one trades higher than the other it is immedately shorted and the other is bought capturing the difference. This makes them trade back in line again with each other.

You got the concept of arbitrage right, but the question is asking what arbitrage prevents, not what arbitrage will lead to.

Arbitrage is the practice of taking advantage of a price difference between two or more markets.

A: Arbitrage prevent market efficiency. incorrect, people prefer to buy cheap goods. Then, it can reduce the mispricing of a good. The definition of the Financial market efficiency is mostly right goods at right price. Thus, Abitrage can make market efficiency.

Reword the question as follows since A is your top choice and C is the actual answer.

A. Does arbitrage prevent market efficiency?

Arbitrage doesn’t prevent market efficiency but rather promotes market efficiency by limiting an essentially risk free profit based on the mispricing of an asset, therefore A is wrong. If an arbitrage opportunity arises it will quickly be exploited since pretty much any rational investor wants risk free profit, e.g.:

ETF 1 & 2 are identical but trade on different exchanges:

ETF 1 currently trading at $25.00/share

ETF 2 currently trading at $24.50/share.

An arbitrage opportunity exists since two identical assets are trading at different prices (ETF 1 is overvalued while ETF 2 is undervalued). Arbitrageurs will go long ETF 2, go short ETF 1 and this arbitrage opportunity will eventually disappear as the two share prices converge. This process has made the market more efficient since the two identical assets are now priced appropriately.

C. Does arbitrage prevent two assets with identical payoffs from selling at different prices?

YES, arbitrage does prevent two assets with identical payoffs from selling at different prices, this is THE fundamental definition of what arbitrage does. As described above, an arbitrage opportunity will be quickly erased if it exists at all since arbitrageurs will buy low, and sell high the undervalued asset while shorting the overvalued asset.

I got that same practice problem wrong. Took a few minutes of brain farting, but finally came around to the reasoning provided above. I can see how that’s an easy mistake though…

What you are saying is also correct but the important issue is - what is the starting point. (1) If at the start of the discussion, markets are efficient, there is of course no scope of any arbitrage. (2) But if at the starting point market are efficient, then arbitrage will exist. Not only it will exist, it will also help markets become efficient.

arbitrage is a phenomenon that the an identical asset selling for different prices in different markets.

Which creats an opportunity for arbitrageur to buy the identical asset with a lower price and sell that at a higher price, meanwhile, expericing no risk.

An arbitrage is a violation of the one-price-law. Yet, it is true that the arbitrageur help to improve the market efficiency because since the active investors believe the existence of arbitrage opportunity, they will keep seeking such opportunities and take advantage of such arbritrage. And when they take the arbitrage, the mass transaction will pull back the balance of price and set the one-law-price back to its position, which, creates the efficiency of market.