Index
A
absence of arbitrage, 4
absolute convergence process, 15
absolute PPP, 76–78
absolute prices, 30
all-equity capital structure, 173
analogies, M&M model, 165–166
APT (Arbitrage Pricing Theory), 4, 28, 37
one-factor model, 37–42
two-factor model, 43–48
arbitrageurs, 2
arbs, 2
Asian Tiger currency crisis, 130
assets
mispriced combinations, 30–32
prices
convergence, 14–15
fairness value, 4–5
Law of One Expected Return, 3
structure, 3–5
riskless modifications, 8
B
backward induction valuation technique, option pricing, 137–138
bank of England, George Soros, 99–100
Bernstein, Peter L., 1
beta, 35
binomial pricing approach (option pricing), 129–132
determinants of option prices, 132–133
one-period
arbitrage-free call prices, 139–140
exploitation of arbitrage opportunity, 140–142
framework description, 133–134
pricing options with backward induction technique, 137–138
riskless portfolios, 135–136
sample application, 138–139
calculating call prices, 143–146
framework description, 142
portfolio rebalancing, 150–155
BSM (Black-Scholes-Merton) option pricing model, 129, 156, 158
C
call options, firm valuation (capital structure analysis), 179–180
capital asset pricing model. See CAPM
capital structure
firm valuation
call options, 179–180
put options, 181–182
put-call parity relationship, 182–185
day-to-day analogies, 165–166
irrelevance of capital structure, 172–173, 175–177
measuring effect of financial leverage, 167, 170–172
Proposition I, 164
Proposition II, 171
CAPM (capital asset pricing model), 4, 28, 34–37
cash and carry arbitrage, 55–57
ceiling, hedging, 11
CFC (Creative Financial Concepts, Inc.)
arbitrage strategy, 173–175
capital structure, 167–168
CIRP (covered interest rate parity), 85–93
combinations, mispriced, 30–32
commodities, mispriced, 28–29
convergence, 14–15
absolute convergence process, 15
asset prices, 14–15
correlation convergence process, 15
corporate leverage, 173
correlation convergence process, 15
cost of carry model
cash and carry arbitrage, 55–57
enforcing with arbitrage, 54–55
foreword versus spot prices, 52–53
interest rate arbitrage, 61–62, 67–68
designing strategy, 63–67
example, 67–68
identifying opportunities, 62
market imperfections, 70
predicting spot prices with forwards, 60–61
rate of return, 54
reverse cash and carry arbitrage, 57–59, 68–70
covered call strategy, put-call parity relationship, 117–121
covered interest rate parity. See CIRP
Creative Financial Concepts, Inc. (CFC)
capital structure, 167–168
cross-rates, triangular currency arbitrage, 94–98
currencies, identifying arbitrage opportunities across, 94–98
D
determinants of option prices, 132–133
domestic Fisher relation, 81
dominance criterion, 22
E
EAI (earnings after interest), 170
earnings per share (EPS), 168
EBI (earnings before interest), 168
economic incentives, Law of One Price, 7
England bank, George Soros, 99–100
EPS (earnings per share), 168
ERM (Exchange Rate Mechanism), 99
European options
option pricing
binomial pricing approach, 129, 132–143, 146–147, 150–155
BSM (Black-Scholes-Merton) option pricing model, 129, 156–158
put-call parity relationship, 104, 107
Exchange Rate Mechanism (ERM), 99
exchange rates
movement, 78–81
nominal interest rates, 83
relative PPP, 78–81
expected rate of return, CAPM, 34–37
expected results, hedging, 10
expected returns
resting, 3
securities, 6
F
financial leverage, capital structure decisions, 167, 170–172
firm valuation (capital structure analysis)
call options, 179–180
put options, 181–182
put-call parity relationship, 182–185
floor, hedging, 11
forward prices versus spot prices, 52–53
forwards
predicting future spot prices, 60–61
predicting spot prices with, 60–61
futures
index arbitrage, 3
positive payoffs, 20–21
zero payoffs, arbitrage at, 20–21
G
general method, formation of synthetic portfolios, 113–114
gold, mispriced commodities, 28–29
Gould, Jay, 115
H
hedge ratios, 136, 146–147, 150
hedging, 3
benefits, 11
ceiling, 11
definition, 9–10
expected results, 10
floor, 11
profits, effects of price on, 11–13
rate of return, 14
hedging (option pricing), 128
hedging transactions, 9
Hong Kong, gold in, 28–29
I-J
implied repo rate, 55
incentives, economic, 7
index arbitrage, 3
initial public offering. See
IPOs interest rate arbitrage, cost of carry model, 61–62, 67–68
designing strategy, 63–67
example, 67–68
identifying opportunities, 62
interest rates, nominal, 83
international arbitrage
absolute PPP, 76–78
domestic Fisher relation, 81
exchange rates, 83
CIRP, 85–93
UIRP, 84–85
interest rates, 83
CIRP, 85–93
UIRP, 84–85
international Fisher rate relation, 82–83
Law of One Price, 76
relative PPP, 78–81
triangular currency arbitrage, 94–98
international Fisher rate relation, 82–83
investments
opportunities for arbitrage, 16–17
negative upfront cost investments, 20–21
portfolios versus individual investments, 17–20
zero cost investments, 20–21
portfolios compared to, 17–20
self-financing, 8
IPOs (initial public offering), 32
irrelevance of capital structure
capital structure arbitrage strategy, 172
CFC (Creative Financial Concepts, Inc.), 173–175
misvalued capital structure, 175
reality of arbitrage, 176–177
K-L
Law of One Expected Return, 3, 36
Law of One Price, 3–7
international arbitrage, 76
relationship to arbitrage, 8
short sales, 32–34
triangular currency arbitrage, 94–98
loans, 115–116
long positions, 10
Long-Term Capital Management. See LTCM
LTCM (Long-Term Capital Management), 129–131
M
M&M (Modigliani-Miller capital structure theory), 164, 187
day-to-day analogies, 165–166
firm valuation
call options, 179–180
put options, 181–182
put-call parity relationship, 182, 185
irrelevance of capital structure, 172
CFC (Creative Financial
Concepts, Inc.), 173–175
misvalued capital structure, 175
reality of arbitrage, 176–177
measuring effect of financial leverage on capital structure, 167, 170–172
Proposition I, 164
Proposition II, 171
market imperfections, 70
market implications, 22
market-neutral arbitrage, 130
Meriwether, John, 129
Merton, Robert, 129
mimicking portfolios, 112
mispriced combinations, exploiting, 30–32
mispriced commodities, 28–29
mispricing, 14–15
misvalued capital structure, 175
models
M&M model, 164–167, 170–182, 185–187
option pricing
BSM (Black-Scholes-Merton) option pricing model, 156–158
one-factor model, 37–42
one-period binomial option pricing, 133–142
two-factor model, 43–48
two-period binomial option pricing, 142–155
Modigliani-Miller capital structure theory. See M&M
movement, exchange rates, 78–81
Mullins, David, 129
Myers, Stewart, 165
N
negative costs, 20–21
new riskless position, 8
New York City, gold in, 28–29
no-arbitrage principle, 16
nominal interest rate, 83
O
one-factor model (APT), 37–42
one-period binomial option pricing model
arbitrage-free call prices, 139–140
exploitation of arbitrage opportunity, 140–142
framework description, 133–134
pricing options with backward induction technique, 137–138
riskless portfolios, 135–136
sample application, 138–139
opportunities for arbitrage, 16–17
identifying across currencies, 94–98
negative upfront cost investments, 20–21
portfolios versus individual investments, 17, 20
zero cost investments, 20–21
options, put-call parity relationship, 117
covered call strategy, 117, 119–121
P
pairs trading, 2
Palm, 32–34
European options, 104–107
mimicking portfolios, 112
regulatory arbitrage, 115, 117
synthetic portfolios, 111–114
personal leverage, 173
pizza analogy, M&M model, 165
portfolio rebalancing, 150–155
poultry analogy, 165
PPP (purchasing power parity), 76
absolute, 76–78
domestic Fisher relation, 81
relative, 78–81
presence of arbitrage, 4
price, 11–13
price/earnings (P/E), 4
prices
absolute, 30
APT
one-factor model, 37–42
two-factor model, 43–48
arbitrage-free, 22
assets
convergence, 14–15
fairness value, 4–5
Law of One Expected Return, 3
Law of One Price, 3–8
cost of carry model
cash and carry arbitrage, 55–57
CIRP, 92–93
enforcing with arbitrage, 54–55
forward prices versus spot prices, 52–53
interest rate arbitrage, 61–68
market imperfections, 70
predicting spot prices with forwards, 60–61
rate of return, 54
reverse cash and carry arbitrage, 57–59, 68–70
mispricing, 14–15
option pricing, 128–129, 158–160
binomial pricing approach, 129, 132–143, 146–147, 150–155
BSM (Black-Scholes-Merton) option pricing model, 129, 156–158
relativity, 30
spot, 60–61
binomial pricing approach, 129–132
determinants of option prices, 132–133
one-period, 133–142
two-period, 142–155
BSM (Black-Scholes-Merton) option pricing model, 129, 156–158
protective put strategy, 121–122
proceeds, short sales, 7
profits
hedging, 11–13
protecting, 10
riskless, 7
Proposition I (M&M model), 164
Proposition II (M&M model), 171
protective put strategy, 121–122
purchasing power parity. See PPP
put options, 181–182
put-call parity relationship, 104, 106–107, 123–125
European options, 104–107
firm valuation (capital structure analysis), 182–185
mimicking portfolios, 112
regulatory arbitrage, 115–117
strategies, 107, 109, 111, 117–119, 121–122
synthetic portfolios, 111, 113–114
Q-R
Quantum Fund, 99–100
rate of return
CAPM, 35–37
cost of carry model, 54
hedging, 14
U.S. Treasury securities, 35
rebalancing portfolios, 150–155
recombining price trees, 143
regulatory arbitrage, 2, 115–117
Reinganum, Marc, 16
relative PPP, 78–81
relativity, 30
resting expected returns, 3
return on assets (ROA), 170
return on equity (ROE), 170
reverse cash and carry arbitrage, 57–59, 68–70
risk arbitrage, 2
risk-free rate, 7
risk-free rate (option pricing), 128
risk-neutral valuation approach (option pricing), 129
riskless modifications, 8
riskless portfolios, 135–136
riskless profit, 7
riskless strategies, 109
risks
risk-free rate, 7
ROA (return on assets), 170
ROE (return on equity), 170
Rubin, Robert E., 27
S
S&P 500, 35–36
S&P 500 Composite Index. See S&P 500
Sage, Russell, 115
sameness, 28
Scholes, Myron, 129
securities
beta, 35–36
expected returns, 6
mimicking portfolios, 112
synthetic portfolios, 111–114
U.S. Treasury, 35
self-financing investments, 8
self-financing strategies, 108
short sales
Law of One Price, 32–34
proceeds, 7
Soros, George, 99–100
spot prices
predicting with forwards, 60–61
versus forward prices, 52–53
stocks
beta, 35–36
option pricing, 128–129
pairs trading, 2
price/earnings (P/E), 4
put-call parity relationship, 117
covered call strategy, 117–119, 121
protective put strategy, 121–122
risk arbitrage, 2
strategies, put-call parity relationship, 107–111, 117–119, 121–122
synthetic loans, 115–116
synthetic portfolios, 111–114
T
tax arbitrage, 2
taxes, 2
theory of capital structure valuation, M&M model, 164–166, 185, 187
time travel, 16
trading, 2
transactions, hedging, 9
triangular currency arbitrage, 94–98
two-factor model (APT), 43–48
two-period binomial option pricing model
calculating call prices, 143–146
framework description, 142
portfolio rebalancing, 150–155
U-Z
U.S. Treasury securities, 35
UIRP (uncovered interest rate parity), 84–85
uncovered interest rate parity. See UIRP
value additively property, 22
wealth, Law of One Price, 6
zero investments, 20–21