by Randall Billingsley
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Product Description
Arbitrage is central both to corporate risk management and to a wide range of investment strategies. Thousands of financial executives, managers, and sophisticated investors want to understand it, but most books on arbitrage are far too abstract and technical to serve their needs. Billingsley addresses this untapped market with the first accessible and realistic guide to the concepts and modern practice of arbitrage. It relies on intuition, not advanced math: readers will find basic algebra sufficient to understand it and begin using its methods. The author starts with a lucid introduction to the fundamentals of arbitrage, including the Laws of One Price and One Expected Return. Using realistic examples, he shows how to identify assets and portfolios ripe for exploitation: mispriced commodities, securities, misvalued currencies; interest rate differences; and more. You'll learn how to establish relative prices between underlying stock, puts, calls, and 'riskless' securities like Treasury bills -- and how these techniques support derivatives pricing and hedging. Billingsley then illuminates options pricing, the heart of modern risk management and financial engineering. He concludes with an accessible introduction to the Nobel-winning Modigliani-Miller theory, and its use in analyzing capital structure.
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Average Customer Review:
4 of 4 people found the following review helpful:
Beautiful job, 2006-12-01
In this short but highly interesting book the author discusses a concept that it is fair to say is an axiom of modern finance: the principle of arbitrage. Even though this principle is not without controversy and has been hotly debated in recent financial research literature, its use in deriving some of the main results in mathematical finance, such as the Black-Scholes equation, is undisputed. To derive the Black-Scholes equation requires somewhat formidable mathematics, and even though it is used, makes the principle of arbitrage seem somewhat artificial. It is not apparent that the principle of arbitrage has any practical significance or indeed has any use outside of the realm of the esoteric field of mathematical finance.
The author of this book is very aware of the need for explaining the concept of arbitrage that is "intuitive" and is accessible to those readers who do not have the deep mathematical background that usually surrounds it. In addition, he also explains the role of "market frictions" in limiting arbitrage opportunities. All of the examples that the author discusses in the book have found application in hedge funds, credit departments, and trading desks throughout the world.
The central theme of the book is what the author calls the `Law of One Price' and which defines the level at which the prices of assets revert to. Arbitrage is then the "action" that brings prices to this level. The author calls this level the "resting place" which reminds one of the notion of equilibrium in economics, but this is somewhat misleading since the price level is due to the intentional actions of agents who are doing everything they can to take advantage of the "free lunch" of an arbitrage opportunity.
The author describes arbitrage opportunities as being "rare" and short-lived, but there are hedge funds and "arb" units all over the globe that make their living finding and exploiting them. Their search has involved the use of highly sophisticated mathematical models and machine intelligence, and critics have charged that this has actually created great instability in the financial markets and levels of risk that are very difficult to manage. Whether this is the case is still unproven, but a strong case can be made that the volatility of the markets is much greater than what it was a few decades ago. Arbitrage opportunities will still come and go in the years ahead, and the level of expertise needed to find them will increase dramatically. It is fascinating that the simple concept of arbitrage that is delineated in this book has resulted in the movement of trillions of dollars and employed thousands of analysts. It will be interesting to see just what kinds of new tools will be deployed to assist in the search for new free lunches.
25 of 25 people found the following review helpful:
Well-known financial concepts , 2006-01-26
“This book traces the common thread binding together much of financial thought – arbitrage. Distilled to its essence, arbitrage is about identifying mispricing and developing strategies to exploit it. An inherently simple concept – the act of exploiting different prices for the same asset or portfolio – arbitrage is as important as it is commonly misunderstood. This is because arbitrage is so often presented in financial arguments that are long on technical detail but short on economic intuition. Many business professionals’ exposure to the concept is limited to the media occasionally associating arbitrage with high-profile financiers, like foreign currency speculator George Soros, or former Secretary of the U.S. Treasury Robert Rubin, once head of arbitrage at Goldman Sachs. Yet such casual mentions do not convey the pervasive importance and usefulness of arbitrage in the world economy or in financial thought. Hence, the goal of this book is to emphasize the intuition of arbitrage and explain how it functions as a common thread in financial analysis. In so doing, I’ll provide concrete examples that illustrate arbitrage in action (from the Preface).”
In this context, Randall S. Billingsley divides this invaluable book into following seven chapters:
1. Arbitrage, Hedging, and the Law of One Price: This chapter explores the relationship between arbitrage, hedging, the Law of One Price, the Law of One Expected Return, and the structure of asset prices.
2. Arbitrage in Action: This chapter illustrates the nature of the Law of One Price, the Law of One Expected Return, arbitrage, and hedging using several examples. These concepts are first illustrated using the example of a discrepancy in the price of gold in two locations.
3. Cost of Carry Pricing: This chapter presents the cost of carry approach to identifying and exploiting mispriced positions. This useful, simple framework portrays the appropriate relationship between spot and forward or future prices. Properly priced forward/futures contracts reflect the cost and benefits of carrying a spot market commodity or security over time. The cost of carry model is illustrated in this chapter using the examples of a commodity, silver, and interest rates.
4. International Arbitrage: This chapter shows how arbitrage influences the relationship among currency exchange rates in light of international interest rate and inflation differences. Foreign exchange rates are structured by arbitrage pressures through international parity relations. Furthermore, this chapter describes various arbitrage strategies involving international interest rates and exchange rates.
5. Put-Call Parity and Arbitrage: This chapter presents the put-call parity relation, which relies on arbitrage to portray the relationship between call and put prices, the underlying stock price, the exercise price, the risk-free rate, and the time to expiration for European options. This chapter also shows how put-call parity lends insight into basic option/stock combination strategies such as the covered call and protective put.
6. Option Pricing: This chapter explains how arbitrage forms the backbone of modern option pricing.
7. Arbitrage and the (Ir)Relevance of Capital Structure: This chapter explains the role of arbitrage in assessing the relevance of capital structure decisions in the context of the Nobel Prize-winning Modigliani-Miller (M&M) theory. The chapter also shows how the firm may be viewed as put and call options and used the put-call parity framework to explain how a firm is valued from the distinct though linked perspectives of bondholders and stockholders.
Highly recommended
8 of 10 people found the following review helpful:
Outstanding book on profitable arbitrage, 2006-01-19
Here is another outstanding book published by the Wharton School, the nation's first collegiate business school, dedicated to publishing books that will have the highest value and impact on the theory and practice of business and management. Randall S. Billingsley, Ph.D., CRRA, CFA distills financial arbitrage to its essence: identifying mispricing and developing strategies to exploit it.
The discussion on arbitrage is often long on technical detail but short on economic intuition. Drawing on extensive (technical and intuitive) experience, Billingsley gives concrete examples of arbitrage in action; his insight into this complex concept is invaluable not only for the sophisticated investor, but for the risk manager, investment analyst, and portfolio manager.
At the end of each chapter, the author gives us a concise Summary and detailed Endnotes which makes the complex subject matter accessible and easily understood.
5 of 7 people found the following review helpful:
Learn the fundamentals of arbitrage and where it occurs, 2006-01-15
Over the years, I have heard of hedge funds and the principal of arbitrage, but until I read this book, I had no idea what they really were. The fundamental definition of arbitrage is where there is an unjustifiable difference in the price of an asset in two separate markets. When this is the case, one can buy in the low market and sell in the high market with no risk whatsoever. Furthermore, the investment is being carried out with someone else's money.
That by itself is easy to understand, but there are several different ways in which an arbitrage situation can be created. Recognizing a true arbitrage situation is difficult and often requires detailed knowledge of the formulas for comparing the values of assets. Therefore, several mathematical formulas are used to demonstrate that an arbitrage condition exists. None of the formulas are difficult, although the basics of algebra are needed to understand them.
Chapter 1 starts with the definition of arbitrage and chapter 2 gives some simple examples of situations where an arbitrage situation exists. The examples are not necessarily found in the real world, but they serve as an excellent introduction to what arbitrage is. Chapters 3 through 6 explain examples of arbitrage situations that can exist in the real world. They are:
Chapter 3: Cost of carry pricing.
Chapter 4: International arbitrage.
Chapter 5: Put-call parity and arbitrage.
Chapter 6: Option pricing.
The seventh and final chapter deals with arbitrage and the essence of the theory of capital structure.
This was one of those books where I was ignorant about the subject before I read the first page and once I completed the last page felt that I had gained a fundamental knowledge of what arbitrage is. That new knowledge has been especially helpful when I have been watching news stories on international monetary markets. This book is an excellent introduction to a topic that is growing in importance as the world economy becomes ever more interconnected.
29 of 30 people found the following review helpful:
Very helpful for someone looking for help in understanding how the principles of arbitrage are used to set prices, 2005-12-13
Arbitrage is one of those words that many people use with only a vague sense of what it means and the vague sense is too often wrong. Many believe it has to do with some kind of crooked speculation in the stock market. In reality, it is a very important idea that allows prices to be set for bonds, stocks, futures contracts, and all kinds of other things.
The basic idea is that if you could go into your local grocery store and see ketchup being actively purchased for $10 a bottle, but you could also buy it across the street for $2 a bottle, you would buy all the $2 bottles you could and take them across the street and sell them for $10. Of course, your bringing more supply might cause the grocery store to lower its price to compete with you. And the $2 store might notice their entire inventory walking out the door and therefore conclude that they can raise the price. This process would continue until both stores were selling the ketchup at nearly the same price. While this isn't pure arbitrage because I have to buy the ketchup first and have some risk of losing my inventory, the idea holds.
There should only be one price in the market for a given thing. However, for a variety of reasons, some of them still not completely understood, there are simultaneous mispricings that traders will seize on and simultaneously buy and sell the good to take advantage of the different prices and continue the trades until the prices again balance. For example, you do not expect to see $100 bills lying in the street. At one time or another you might see one and you would immediately pick it up. Then there would no longer be $100 bills in the street. The principle that you don't expect to see $100 bills in the street is similar to the idea that you should not see different prices for the same thing in the market. They might come along, but when they do they will instantly be traded away (usually by computers programmed to watch for them), so you shouldn't plan on making a living trading for them. However, being aware of the possibility might allow you see the odd $100 when it, rarely, is on the ground right in front of you.
However, the real purpose of knowing about arbitrage is more for learning about how to value equities, bonds, forward contracts, and futures. This book provides excellent supplementary material for a course in these subjects. General textbooks on the subject do cover the material, but rather quickly. Sometimes trying to get your mind around this stuff for the first time is like trying to draw looking in a mirror with someone waving her hands in front of your eyes.
Now, there are mathematical formulas in this book. That might lead some to wonder why the approach here is called intuitive. That is because what is provided here is given the reader as a tool for understanding the ideas. If you were to take a course in deriving and proving the material simply asserted here, well that is much heavier lifting. So, the reader does need to be able to read some basic math symbols such as delta and beta and some basic concepts along these lines. The author points the reader to glossaries and helps for those who need them.
So, this is NOT a book teaching you how to make a killing trading in arbitrage opportunities. It is a fine effort to help you understand why the market tends towards one price for a given thing and how those prices are derived. It is ideal for MBAs taking a course in this area and needing some extra help. However, the general reader interested in this subject can also find this very valuable.
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