Introducing Arbitrage

Abstract

While arbitrage is an integral part of the study of derivatives and of corporate finance, it appears also in money and banking and in international economics. Students find it difficult to develop intuition concerning arbitrage situations and trying to learn how to apply the concept at the same time increases the difficulty. I separate the two problems for them by introducing students to the notion of arbitrage first in a simple context. There they can develop some facility in the use of the ideas before plunging into the harder study of more complicated ideas. Starting with two securities, which can be converted one for the other at some date in the future, I add complications (including statecontingent pay-offs) until students can see how any two assets which are even temporarily "the same" can give rise to arbitrage opportunities if they are not equal in price today and how a complex security might be thought of as a bundle of simpler securities and therefore can then be priced as the sum of the component prices. I also point out how each example shows not only how to execute an arbitrage strategy but how much can sometimes go wrong.