This document discusses arbitrage and synthetic instruments. It begins by defining arbitrage as profiting from price discrepancies between markets through simultaneous transactions. It then discusses the history of arbitrage from ancient times to modern day. Key risks in arbitrage in India include execution lags, interest rate uncertainty, transaction risk, and default risk. The document also covers other types of arbitrage like pure arbitrage and futures arbitrage. It concludes by listing some impediments to arbitrage in India such as lack of liquidity, regulatory anomalies, inadequate infrastructure, and lack of knowledge.

1. ARBITRAGE AND SYNTHETIC
INSTRUMENTS
1

2. CONTENTS
2
MEANING OF ARBITRAGE
ARBITRAGE: FROM ANCIENT TO MODERN
RISKS IN ARBITRAGE IN INDIA
MARKETS WHERE ARBITRAGE IS USED
OTHER TYPES OF ARBITRAGE
IMPEDIMENTS TO ARBITRAGE IN INDIA

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SYNTHETIC SECURITIES
CASH AND CARRY SYNTHETIC
CREATING SYNTHETIC LONG BONDS
USING SWAPS TO SYNTHESIZE POSITIONS
QUALITATIVE DIFFERENCE BETWEEN
SYNTHETICAND REAL SECURITIES

4. MEANING OF ARBITRAGE
4
Arbitrage is a profit-making activity which involves two
or more simultaneous transactions in different markets in
order to take advantage of price, time, space, legal,
regulatory discrepancies between them.

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 Example:
Infosys is quoting at $250 on the BSE and $260 on the NSE.
Hence, one can sell stock on the NSE and buy from the BSE at
the same time.
This trade will lead to profit without any risk. This process is
known as arbitrage.

6. ARBITRAGE: FROM ANCIENT TO MODERN
6
As stated earlier, arbitrage involves simultaneous transactions in
two or more markets in order to exploit price, time, space, legal,
regulatory discrepancies between the markets.
There are many different forms of arbitrage. The most intuitively
obvious form involves the purchase of a commodity in one
market and the simultaneous sale of the same commodity in
different markets.
When a sufficiently large price discrepancy does develop,
arbitragers will quietly act to exploit it.

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Purchased in :
Lower Price Market(where it is said to be cheap) and,
Sold in :
High Priced Market (where it is said to be rich).

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The arbitrager, seeks to profit from the discrepancy between the
markets. This form of arbitrage is called Spatial Or Geographic
Arbitrage, and is one of the earliest forms of arbitrage.
Indeed, in the sense it is the functional in which the merchant
activity rests. In order, for spatial arbitrage to be profitable, the
price discrepancy between the two markets must be sufficiently
great to cover the transactions and transportation cost
involved.

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 EXAMPLE:
Commodity can be moved between Market 1 and Market 2, at :
 Transportation Cost : T 1, 2
 Transactions Cost : R 1, 2
Then spatial arbitrage is only profitable if:
 The price of the commodity is more than T 1, 2 + R 1, 2.

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If there are no artificial barriers to trade, the activities of the
spatial arbitragers described above should ensure that the
prices of the same commodity in the different market never
deviate by more then the cost of transportation and
transaction.
Indeed, this thinking led to the development of a theory of
geographic market equilibrium now known as the law of one
price.

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The law of one price states that:
 Price in Market i, denotes P i
 Price in Market j denotes P j
are related as defined by the following equation :
P i = P j + Z i, j (eq. 1)
Z i, j = (T i, j + R i, j)
In simple words, the price in Market i can be as high as
P j + (T i, j + R i, j) or as low as P j- (T i, j + R i, j) without
giving rise to profitable arbitrage opportunities.

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The law of one price can be generated to allow for different
currencies.
 EXAMPLE:
If the price of the commodity in Market i is stated in Currency
iand the Price in Market j is stated in Currency j, then the law
of one price must also reflect the exchange rate between
Currency i and Currency j.

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If we denote, this exchange rate by E i, j , then the law of one
price is stated by the following equation :
P i = P j. E i,j + Z i,j ( eq. 2)
Equation 2 is interpreted as follows:
The Price of the commodity in Market i stated in Currency i
must be equal the Price in Market j in Currency j times the
exchange rate of Currency i for Currency j.
Z i, j is same as observed earlier stated in terms of Currency i.

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The law of one price can be expanded to allow for commodities that
are different but that are convertible into each other.
 EXAMPLE:
Gold trades on some exchanges in 95% purity but on other exchange
in 99% purity. Thus, the 95% purity standard of is not deliverable
against the 99% purity standard of the other market. But, at some
expense, 95% gold can be converted to 99% gold by something the
gold and as convertibility cost.
Equation (2) then will become:
P i = P j . E i,j + Z i,j (eq. 3)
Here, Z i, j = (T i, j + R i, j+ Ci,j)

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Another type of arbitrage that has long been practiced is
temporal arbitrage, something called carrying – charge
arbitrage.
In this form of arbitrage the market in which the commodity is
bought and the market in which it is sold differ temporarily
rather than spatially.

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 EXAMPLE:
An arbitrager observed that the commodity for immediate (spot)
delivery, can be purchased for Pi (t) and sold for later
(forward) delivery for Fi (t,T).
The difference between Fi (t,T) and Pi(t) should be equal to the
cost of carry, i.e. :
Fi (t,T) - Pi(t) = Gi (t,T)
or, Fi (t,T) = Pi(t) + Gi (t,T) (eq. 4)
Here, Gi (t,T) is the cost of carry.

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 Equation 3: Spatial Equilibrium Condition
 Equation 4: Temporal Equilibrium Condition
If Fi (t,T) was greater than the RHS of equation 4, the
arbitrager would long spot commodity and short commodity for
forward delivery.
If Fi (t,T) is less than the RHS of equation 4, then arbitrager
would short the spot commodity and long commodity for
forward delivery.

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 The spatial equilibrium condition and the temporal
equilibrium conditions represented by equation 3 and equation
4 respectively, can be combined to provide a more general
equilibrium condition that can explain both spatial and temporal
price relationship:
Fi(t,T) = Pj(t). E i,j(t) + Gi(t,T) + Zi,j (eq. 5)

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Through proper structuring and diversification of a portfolio,
very risky individual positions can be held with very little overall
risk. If the parties bearing the individual risks are willing to pay a
sufficiently large premium to be relieved of them, then the
arbitrage can be profitable.
In academic circles, arbitrage is often described as a profitable
business activities involving no risk.

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Indeed, when using this definition, we often make our meaning
clear by specifying academic or pure arbitrage. The academic
definition, assumes that all transactions, including both the
purchase and sale, can be transacted simultaneously, and that the
positions can be financed entirely from loans (no equity).
In practice, real world arbitrage generally cannot be effectively
conducted without some, atleast, temporary, investment and it is
rarely completely risk free.

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For eg. Suppose an arbitrager spots an exploitable market
mispricing. He attempts to profit by buying in the cheap market
and selling in the (high-priced) rich market.
If the two transaction can be effected simultaneously by saying
“done” to the selling and buying parties, then there is no
transaction risk.

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But, in practice it will usually happen that the transactions are
only near simultaneous. A split second passes between the
buying and the selling transactions. It is possible that one of the
opposing parties may withdraw his or her bid or offer, before the
second transaction can be effected.
It is also possible that, even if both of the sides of arbitrage are
affected simultaneously, that one of the party may default.
Many potentially profitable arbitrage opportunities have gone
sour because of default.

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Given these realities, a better definition of arbitrage might be:
“A business transaction undertaken to even a low – risk profit
on little investment by exploiting a pricing discrepancy
between 2 or more markets.”

24. MARKETS WHERE ARBITRAGE IS USED
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Stock Market
Bond Market
Derivatives Market
Commodity Market
Foreign Exchange Market

25. RISK IN ARBITRAGE IN INDIA
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Execution
Lags
Interest
Rate
Uncertainty
Transaction
Risk
Default
Risk

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 EXECUTION LAGS
In the ideal world, traders placed to capture an arbitrage
opportunity would be instantaneously executed. However, in the
real world, execution takes time. Very often, there can be
variations in price between the time an arbitrage opportunity is
entered into and the time the trade is actually executed on the
market.

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 INTEREST RATE UNCERTAINTY
An arbitrator who enters into an arbitrage trade assumes that a
particular level of interest rate will remain constant. In the cash
and carry strategy, the arbitrager assumes that he will be able to
borrow at a certain rate till the expiration of future contract.
Similarly, he makes assumption in other strategies.
However, the uncertainty about the interest rate that will be
charged on the capital that is deployed and the returns that
would be generated from the funds deployed in money market,
have a bearing on the profits generated form arbitrage positions
undertaken.

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 TRANSACTION RISK
Arbitrager attempts to make profit by buying in cheap market
and selling in rich market. In practice it usually happens that the
transactions are only near simultaneously.
A split second passes between the buying and the selling
transaction. It is possible that one of the opposing party may
withdraw his or her offer, before the second transaction is
affection, so this a transaction risk involved in arbitrage.

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 DEFAULT RISK
Sometimes both sides of arbitrage are effected simultaneously,
but one of the party may default, that is known as default risk,
many potentially profitable arbitrage opportunities have gone
sour because of default.

30. OTHER TYPES OF ARBITRAGE
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 PURE ARBITRAGE
The pure arbitrage is the one in which, one has two assets with
identical cash flow and different market prices.
It includes two aspects:
1. Identical assets are not common in real world. No two
companies are exactly alike, and their stocks are therefore not
perfect substitutes.
2. Second, assuming two identical assets exists, one has to wonder
why financial markets would allow price differences to persist.

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 FUTURE ARBITRAGE
A future contract is to deliver (sell) or take delivery (buy) of a
standardized quantity of an underlying commodity/instrument at
a pre-established price, agreed on a regulated exchange at a
specified future date.
In future contract one party agrees to deliver the asset at the
specified time in the future, and the other party agrees to pay a
fixed price and take delivery of the asset.

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 OPTIONS ARBITRAGE
As derivative securities, options differ from futures in a very
important respect. There are rights rather than obligations, calls
gives you the right to buy and puts gives you the right the sell an
underlying asset at a fixed price called an exercise price.
Consequently, a key feature of options is that buyers of option
will exercise the options only if it is in their best interests to do so
and thus cannot lose more than what was paid for the option, i.e.
option premium.

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 SPECULATIVE ARBITRAGE
It is really not an arbitrage in first place. In this investors take
advantage of what they see is mispriced, buying the cheaper one
and selling the expensive one, but it actually expose investors to
significant risk.

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 UNCOVERED INTERST ARBITRAGE
In case of uncovered interest arbitrage, funds or monies are sent
to another country for availing the benefit of increased interest
rates in forex agencies.
 REGULATORY ARBITRAGE
In this type of arbitrage, a regulated organization avails the
benefit of deviation between the regulatory positioning and the
economic risk.

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 CASH AND CARRY ARBITRAGE
It is a combination of a long position in an asset and a short
position in underlying futures. This arbitrage strategy seeks to
exploit pricing inefficiencies for the same asset in cash and
future market, in order to make riskless profits.
The arbitrager “carry” the asset till the expiration of future
contract, at which point it would be delivered against future
contract.

36. IMPEDIMENTS TO ARBITRAGE IN INDIA
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Lack of liquidity and depth
in the spot market
Anomalies in regulation and
taxation of arbitrage traders
Inadequate IT infrastructure
Lack of knowledge