stedwick

January 19th 2008, 12:43 AM

Arbitrage is one concept that I continually have trouble on. So, I'm curious, what was the "blaze of light" that hit you when you felt that you really understood arbitrage?

For me, I feel like I'm stuck with the chicken or the egg dilemma.

When I look at the solution to an arbitrage problem, and I do the math, I obviously understand that it comes out with a positive profit all the time. The problem is, I don't know if there's an arbitrage until I do the math, and I can't do the math until I know what the arbitrage is so that I know what to calculate. Do you see what I'm saying? I don't yet have an arbitrage "intuition".

I often come across problems that say, "Here's various information about some options. There is a mispricing that results in an arbitrage opportunity. What is your profit after one year if you exploit this opportunity?"

I have a real hard time with these problems. First, I wouldn't have known there was a mispricing unless the problem told me so. Although, I'm getting better at that. Put call parity, and various other option pricing methods, will reveal if the option is overpriced or underpriced. However, I'm still shaky on how exactly to construct a position that exploits the mispricing.

Solutions to these problems always say things like, "If you short three shares of stock, buy two call options and sell five put options, and borrow $59, voilą, you've exploited the arbitrage opportunity." I do the math, and, sure enough, a profit is inevitable. But, setting up this opportunity still seems like magic to me.

Anyway, do you guys have any stories of "a-ha moments" regarding arbitrage?

Philip

For me, I feel like I'm stuck with the chicken or the egg dilemma.

When I look at the solution to an arbitrage problem, and I do the math, I obviously understand that it comes out with a positive profit all the time. The problem is, I don't know if there's an arbitrage until I do the math, and I can't do the math until I know what the arbitrage is so that I know what to calculate. Do you see what I'm saying? I don't yet have an arbitrage "intuition".

I often come across problems that say, "Here's various information about some options. There is a mispricing that results in an arbitrage opportunity. What is your profit after one year if you exploit this opportunity?"

I have a real hard time with these problems. First, I wouldn't have known there was a mispricing unless the problem told me so. Although, I'm getting better at that. Put call parity, and various other option pricing methods, will reveal if the option is overpriced or underpriced. However, I'm still shaky on how exactly to construct a position that exploits the mispricing.

Solutions to these problems always say things like, "If you short three shares of stock, buy two call options and sell five put options, and borrow $59, voilą, you've exploited the arbitrage opportunity." I do the math, and, sure enough, a profit is inevitable. But, setting up this opportunity still seems like magic to me.

Anyway, do you guys have any stories of "a-ha moments" regarding arbitrage?

Philip