Chapter 7: Arbitrage, Replication, and Cost of Carry

In this section

• Principles of No-Arbitrage and the Law of One Price
  An advanced yet slightly informal exploration of no-arbitrage conditions and the law of one price, highlighting their significance in modern derivatives pricing, market efficiency, and arbitrage trading.
• Replicating Payoffs with Derivatives
  Learn how to replicate derivative payoffs using underlying assets and risk-free bonds to eliminate mispricing, with practical insights into dynamic hedging, binomial models, and real-world constraints.
• Cost of Carry Model for Pricing
  In-depth exploration of the cost of carry model for pricing derivatives, focusing on forward and futures fair value, net carry costs, and arbitrage opportunities.
• Cash-and-Carry and Reverse Cash-and-Carry Strategies
  Explore the mechanics of cash-and-carry and reverse cash-and-carry arbitrage in futures markets, including practical step-by-step examples, risk-free profit analysis, and real-world considerations affecting these trades.
• Mechanics of Arbitrage in Practice
  Explore real-world arbitrage implementation, margin accounts, short-selling logistics, electronic trading, prime brokerage, and how transaction costs plus settlement risks may complicate theoretically risk-free strategies.
• Practical Limitations to Arbitrage and Market Frictions
  Explore how real-world constraints, from bid–ask spreads to short-sale bans, limit arbitrage opportunities, emphasizing the impact of market frictions and regulations in derivative markets.
• Multi-Asset Arbitrage Strategies
  Explore how traders detect and exploit cross-asset mispricings through relative value techniques, correlation analyses, and cross-hedging methods.
• Lease Rate Arbitrage
  Explore lease rate arbitrage mechanics, focusing on precious metals, cost of carry, and opportunities driven by mispriced forward contracts and lease rates.
• Index Arbitrage in Equity Futures
  Explore the mechanics and strategies behind exploiting mispricing between equity index futures and their underlying stocks, including cost-of-carry, program trading, and automated execution.
• Conversion and Reversal Option Arbitrage
  Explore how conversion and reversal strategies exploit mispricings in the options market, leveraging put–call parity to generate near risk-free profits.
• Synthetic Positions in Derivative Arbitrage
  Learn how to replicate or replace derivative payoffs through synthetic positions, exploring the intricacies of arbitrage strategies in derivative markets, payoff replication, and potential market frictions.
• Pairs Trading as a Form of Arbitrage
  An in-depth exploration of pairs trading, a relative-value strategy for exploiting mispricings between correlated assets through long–short combinations.
• Mispricing Measures and Price Discovery
  Comprehensive exploration of how arbitrage and real-time market dynamics drive price discovery and eliminate mispricing in derivative markets.
• Arbitrage in Crypto Futures and Perpetual Swap Markets
  Explore how no-arbitrage principles apply in crypto futures and perpetual swaps, learn cross-exchange strategies, and navigate funding rate imbalances in high-volatility digital asset markets.
• Triangular Arbitrage in Currency Derivative Markets
  Learn how mismatched currency exchange rates can create risk-free arbitrage opportunities across spot and forward contracts, while discovering key mechanics, best practices, and exam insights for CFA candidates.