What is Arbitrage?

Short answer

Arbitrage is making a sure profit in excess of the risk-free rate of return. In the language of quantitative finance we can say that an arbitrage opportunity is a portfolio of zero value today which is of positive value in the future with positive probability, and of negative value in the future with zero probability.

The assumption that there are no arbitrage opportunities in the market is fundamental to classical finance theory. This idea is popularly known as ‘there’s no such thing as a free lunch.’

Example

An at-the-money European call option with a strike of $100 and an expiration of six months is worth $8. A European put with the same strike and expiration is worth $6. There are no dividends on the stock and a six-month zero-coupon bond with a principal of $100 is worth $97.

Buy the call and a bond, sell the put and the stock, which will bring in $ − 8 − 97 + 6 + 100 = $1. At expiration this portfolio will be worthless regardless of the final price of the stock. You will make a profit of $1 with no risk. This is arbitrage. It is an example of the violation of put–call parity.

Long answer

The principle of no arbitrage is one of the foundations of classical finance theory. In derivatives theory it is assumed during the derivation of the binomial model option-pricing algorithm and in the Black–Scholes model. In these cases it is rather more complicated than the simple example given above. In the above example we set up a portfolio that gave us an immediate profit, and that portfolio did not have to be touched until expiration. This is a case of a static arbitrage. Another special feature of the above example is that it does not rely on any assumptions about how the stock price behaves. So the example is that of model-independent arbitrage. However, when deriving the famous option-pricing models we rely on a dynamic strategy, called delta hedging, in which a portfolio consisting of an option and stock is constantly adjusted by purchase or sale of stock in a very specific manner.

Now we can see that there are several types of arbitrage that we can think of. Here is a list and description of the most important.

• A static arbitrage is an arbitrage that does not require re-balancing of positions.
• A dynamic arbitrage is an arbitrage that requires trading instruments in the future, generally contingent on market states.
• A statistical arbitrage is not an arbitrage but simply a likely profit in excess of the risk-free return (perhaps even suitably adjusted for risk taken) as predicted by past statistics.
• Model-independent arbitrage is an arbitrage which does not depend on any mathematical model of financial instruments to work. For example, an exploitable violation of put–call parity or a violation of the relationship between spot and forward prices, or between bonds and swaps.
• Model-dependent arbitrage does require a model. For example, options mispriced because of incorrect volatility estimate. To profit from the arbitrage you need to delta hedge, and that requires a model.

Not all apparent arbitrage opportunities can be exploited in practice. If you see such an opportunity in quoted prices on a screen in front of you then you are likely to find that when you try to take advantage of them they just evaporate. Here are several reasons for this.

• Quoted prices are wrong or not trade able
• Option and stock prices were not quoted synchronously
• There is a bid–offer spread you have not accounted for
• Your model is wrong, or there is a risk factor you have not accounted for

References and Further Reading

Merton, RC 1973 Theory of rational option pricing. Bell Journal of Economics and Management Science 4 141–183

Wilmott, P 2007 Paul Wilmott Introduces Quantitative Finance, second edition. John Wiley & Sons Ltd

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Understanding the Financial Crisis - very well explanation!

'Saving is sin, and spending is virtue.'

Interesting article written by an Indian Economist.

Japanese save a lot. They do not spend much. Also, Japan exports far more than it imports. Has an annual trade surplus of over 100 billions. Yet Japanese economy is considered weak, even collapsing.

Americans spend, save little. Also US imports more than it exports. Has an annual trade deficit of over $400 billion. Yet, the American economy is considered

strong and trusted to get stronger.

But where from do Americans get money to spend? They borrow from Japan, China and even India. Virtually others save for the US to spend. Global savings are mostly invested in US, in dollars.

India itself keeps its foreign currency assets of over $50 billions in US securities. China has sunk over $160 billion in US securities. Japan 's stakes in US securities is in trillions.

Result:

The US has taken over $5 trillion from the world. So, as the world saves for the US - Its The Americans who spend freely. Today, to keep the US consumption going, that is for the US economy to work, other countries have to remit $180 billion every quarter, which is $2 billion a day, to the US !

A Chinese economist asked a neat question. Who has invested more, US in China , or China in US? The US has invested in China less than half of what China has invested in US.

The same is the case with India .

We have invested in US over $50 billion. But the US has invested less than $20 billion in India.

Why the world is after US?

The secret lies in the American spending, that they hardly save. In fact they use their credit cards to spend their future income. That the US spends is what makes it attractive to export to the US . So US imports more than what it exports year after year.

The result:

The world is dependent on US consumption for its growth. By its deepening culture of consumption, the US has habituated the world to feed on US consumption. But as the US needs money to finance its consumption, the world provides the money.

It's like a shopkeeper providing the money to a customer so that the customer keeps buying from the shop. If the customer will not buy, the shop won't have business, unless the shopkeeper funds him. The US is like the lucky customer. And the world is like the helpless shopkeeper financier.

Who

is America 's biggest shopkeeper financier? Japan of course. Yet it's Japan which is regarded as weak. Modern economists complain that Japanese do not spend, so they do not grow. To force the Japanese to spend, the Japanese government exerted itself, reduced the savings rates, even charged the savers. Even then the Japanese did not spend (habits don't change, even with taxes, do they?). Their traditional postal savings alone is over $1.2 trillions, about three times the Indian GDP. Thus, savings, far from being the strength of Japan , has become its pain.

Hence, what is the lesson?

That is, a nation cannot grow unless the people spend, not save. Not just spend, but borrow and spend. Dr. Jagdish Bhagwati, the famous Indian-born economist in the US , told Manmohan Singh that Indians wastefully save. Ask them to spend, on imported cars and, seriously, even on cosmetics! This will put India on a growth curve. This is one of the reason for

MNC's coming down to India , seeing the consumer spending.

'Saving is sin, and spending is virtue.'

But before you follow this Neo Economics, get some fools to save so that you can borrow from them and spend !!!

Regards,

Premji Bhawan

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Value of a Firm (Using Operating Free Cash Flows)

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt. Any firm’s objective is to maximize its value for the shareholders. The value of the firm can be measured as the present value of the operating free cash flows over time.

The value of the firm can be expressed using the following formula:

 Where:

V is the Value of the firmOFCF is the Operating Free Cash Flow After TaxAnd WACC is the Weighted Average Cost of Capital 

The Operating Free Cash Flow (OFCF) is measured as:OFCF = Revenue – Operating Expenses – Capital Expenditure

The Weighted Average Cost of Capital (WACC) is measured as:

 Where:

r_e = Cost of equity
r_d = Cost of debt
E = Value of the firm’s equity
D = Value of the firm’s debt
V = E + D
E/V = Percentage of equity financing
D/V = Percentage of debt financing
t = Tax rate 

The expected future cash flows of a firm can also be expressed as a perpetuity. In that case, the firm’s value can simply be expressed as:

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Why Issue of Additional Equity Leads to Share Price Fall?

It is generally observed that when a firm issues additional equity, the share prices fall. Why does that happen? Since the firm uses equity in value-adding investments, it may surprise people that the stock prices actually fall.

One explanation of this phenomenon can be given by the theory of information asymmetry. According to this concept the management has more information about the prospects of the firm, compared to shareholders, debt-holders and other stakeholders.

We also know that the management issues more equity when the equity value is high.

Since the management knows best, when they issue additional equity, the market interprets that the equity is overvalued. And therefore the stock prices fall.

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Rogue trader suspected in $2 billion loss at UBS

Friday, September 16, 2011

By FRANK JORDANS and GREGORY KATZ

LONDON - One man armed with only a computer terminal humbled a venerable banking institution yet again. This time it was Swiss powerhouse UBS, which said Thursday that it had lost roughly $2 billion because of a renegade trader. 

The arrest of 31-year-old equities trader Kweku Adoboli in London is one more headache for troubled international banks, and fresh proof that they remain vulnerable to untracked trading that can produce mind-boggling losses. 

Adoboli would join a rogue's gallery that includes Jerome Kerviel, who gambled away $6.7 billion at a French bank until he was caught three years ago, and Nick Leeson, who made so many unauthorized trades that it caused the collapse of a British bank in 1995. 

The scale of those frauds rocked world finance. Banks tightened oversight rules to make sure such large sums could not be traded under the radar. But the safeguards, designed to protect the public and shareholders alike, seem to have failed. 

UBS discovered irregularities in its trading records Wednesday night, and Adoboli was arrested early Thursday. Swiss banking regulators began looking into the scandal, which sent the bank's stock sharply lower. 

"From the scale of this case, you can be sure that it's the biggest we've ever seen for a Swiss bank," Tobias Lux, a spokesman for Swiss regulators, told The Associated Press. 

Analysts said the bank's image would be badly hurt. UBS was deemed to have recovered from the lending crisis that hammered banks in 2008 and to have improved its management of risk, said Fionna Swaffield, a bank analyst at RBC Capital Markets. 

"This obviously brings this very much into question," she said. 

Details about the alleged fraud were scarce. In a terse statement shortly before markets opened, UBS informed investors that a large loss due to "unauthorized trading" had been discovered. 

The bank estimated the loss at $2 billion, big enough that the bank said it might have to report a quarterly loss. 

In a letter to employees, the bank said it regretted that the incident came at a difficult time: "While the news is distressing, it will not change the fundamental strength of our firm." 

Adoboli was being held by London police. There was no word on whether he had retained a lawyer. 

According to his profile on LinkedIn, a social networking site for professionals, Adoboli served on an equities desk at UBS called Delta One and worked with exchange-traded funds, which track different types of stocks or commodities, like gold. It is the same type of work Kerviel did for his bank. 

UBS added extra security at its offices in London's financial district, and reporters were told that no additional information would be provided and were asked to leave. 

Philip Octave, Adoboli's former landlord at an expensive loft near the financial district, described him as articulate and well-dressed, and said he did not cause substantial problems. 

"He was very nice, very polite," Octave said. He said Adoboli was untidy and had fallen behind on the rent on two occasions but paid up after some prodding. He said there were no problems with Adoboli's references. 

The rent was a hefty 4,000 pounds per month, or about $6,300. Once downtrodden, Adoboli's neighborhood has become popular with traders who can walk to work. It is popular with tourists because of its antique shops and vintage clothing stores. 

The apartment, which Adoboli left four months ago, was in a handsome three-story brick building near London's storied Brick Lane - a busy street of curry houses, bars and boutiques a few blocks from UBS's modernist U.K. headquarters. 

Adoboli traveled often to France and the United States, had been dating a nurse for at least a year and enjoyed the neighborhood bars, Octave said. The University of Nottingham said he graduated in 2003 with a degree in e-commerce and digital business. 

Adoboli's profile on Facebook showed a smiling black-and-white photograph and listed his interests as photography, cycling and boutique wines. The profile was taken down hours after his arrest.

UBS is struggling to restore its reputation after heavy losses from subprime mortgages and an embarrassing U.S. tax evasion case that blew a hole in Switzerland's storied tradition of banking secrecy. UBS took a $60 billion bailout from the Swiss government in 2008. 

The bank already planned to cut 3,500 jobs over two years, and the $2 billion loss is likely to further anger shareholders. Its stock closed 11 percent lower in Zurich on Thursday. In the United States, it trades at about one-sixth what it did in 2007. 

UBS said the trading was under investigation and no client money was involved. 

Peter Thorne, a London equities analyst at Helvea, said the loss was manageable for UBS but a blow to its reputation and management. He said it would probably add to calls for UBS to cut back its investment banking unit. 

Banking industry observers immediately highlighted similarities to the Kerviel case, which also involved a young trader entrusted with vast sums of money. 

Kerviel, who traded at Societe Generale, France's second-largest bank, was convicted in October 2010 of covering up bets worth almost $68 billion in all, with losses of $6.7 billion. 

He was ordered to pay the bank back all the money he had lost and was banned for life from the financial industry. Kerviel has appealed the verdict. 

Leeson lost $1.38 billion, or about $2 billion in today's dollars, betting on Asian futures markets for Barings bank until he was discovered in 1995. The bank, which had been in business for more than 230 years, collapsed. 

By coincidence, the Swiss parliament began a long-slated debate on the future of the country's banking industry Thursday. 

Lawmakers are being asked to consider proposals to assure that Switzerland's two biggest banks, UBS and Credit Suisse Group, are brought under tighter control. Some lawmakers want the banks split up to make sure they are not "too big to fail" - so massive that they would wreak enormous damage on the economy if they went under. 

--- 

Jordans contributed from Geneva. John Heilprin in Geneva, and Paisley Dodds, Bob Barr, Raphael G. Satter and Pan Pylas in London contributed to this report.

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FBR confirms 24,000 containers missing

Chairman Pakistan’s Federal Borad of Revenue (FBR) has confirmed that some 24,000 containers have gone missing from January 2007 to October 2010.

While giving briefing to National Assembly’s standing committee meeting, Salman Siddique said that about 350,000 containers were bring into Pakistan under Afghan Transit Trade from January 2007 to October 2010.

He also confirmed that 265 containers of ISAF – International Security Assistance Force – were also lost during this period.

He assured that the investigation of the missing containers has almost completed.

He maintained that national deposits will suffer a loss of Rs five billions due to the missing container because a number of duties and taxes would not be paid.

Chairman FBR also admitted that the objective of flood surcharge could not be attained.

He also said that show-cause notices have been issued to the culprits including importers, clearing agents, terminal/port operators, custom officials, shipping agents and transporters.

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5 things to remember when marketing to Arab women

If women are complicated, it’s only because you haven’t reach out to them properly.

When you’re targeting women in your marketing campaign keep these important points in mind:

 

1. Women are not only mothers

Not every woman is a mother or a housewife. Among women there are endless sub-groups you can target. Study them carefully before making assumptions about your consumer group.

 

2. Culture plays a big role

While women across regions and cultures can relate on many levels, you can’t ignore their differences either. Women consumers in the Middle East will be very different from women consumers in the Western world. Remember, you’re trying to reach out to them, not change them.

 

3. Purchasing power varies

Do not assume that either the man of the house or the woman of the house is solely in charge of the family’s purchases. More and more women are becoming self-sufficient long before they start a family and often the budgeting and purchasing are a shared responsibility in Arab households.

 

4. Women on your team

While you’re not obliged to do so, it might not be such a bad idea to have women on your team to help you get into the life and minds of women. Of course by no means should you hire anyone, man or woman, if they are not the best possible candidate for the job. Qualifications come first. Gender is just a bonus.

 

5. Your medium will matter

Figures show that despite the increase of women on Facebook in the last year, the numbers are still low. Before diving head-first into social media, discover what works best for your campaign; consider the places where most women notice and inquire about products and services that interest them.

 

 

What ideas do you find useful for marketing to women, especially in the Middle East?

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10 ideas local brands teach about marketing

In the Middle East we often look outside of our region for marketing inspiration. However, there are a thing, or 10, that the marketing industry can learn from local brands.

1. Connections count

Knowing the right people in the right industry can still (although doesn’t always have to) make or break your brand.

 

2. Tradition will thrive

Campaigns and ads that include a cultural or traditional reference are often more popular.

 

3. Sex doesn’t have to sell

The infamous saying, “sexy sells,” doesn’t always apply. Middle Eastern audiences relate more to other symbols in marketing campaigns. Why do you think Nancy sang Waving Flag during the World Cup and not Haifa?

 

4. Humor is important

Sex may not sell, but humor certainly does! And when done right, it quickly becomes viral.

 

5.English is not king

As much as we would like to think of the Middle East as a global melting pot, Arabic audiences have proved they still very much prefer to receive their communication in Arabic.

 

6. History plays a role

The Middle East is a region that has experienced decades of commotion in its history and politics. Historical triumphs cannot go unnoticed, even in the marketing industry.

 

7. Offline beats online

While this is slowly changing, a huge chunk of consumers in the Middle East (and possibly other parts of the world) are still offline. It’s still the more potent option.

 

8. Price still matters

Fancy new products and services are exciting to everybody around the world, but in the Arab world, price still needs to be reasonable. Who needs a nicely packaged fruit juice when you can squeeze your own oranges at home?

 

9. Trust is a last resort

The first instinct of most Arab consumers is to dismiss the message, promise or deal in a marketing campaign as a lie or a catch. Trust takes a lot more time to establish than you would like to think.

 

10. TV cannot be forgotten

Many say TV is a dying medium, but this is anything but true in the Middle East. With talk shows becoming one of the most-viewed program types Arabs are still spending a lot of time watching TV – even the tech-savvy folks.

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Things marketers still can’t get from social media

As much as we would like to think that social media has taken over the world of marketing, there are still several things it cannot do for us.

Measure ROI

You social media marketing strategy may have helped you make your brand or company much more successful in the last couple of months. However, you still cannot directly measure what the return on your social media investment was. For all you know, your Twitter account just made you popular online but brought in no revenue.

 

Personalized service

While brands have been getting creative with ways to personalize messages, responses and random acts of kindness online, they still lag behind. Dealing with a customer face-to-face instantly makes an interaction more personal and meaningful, way beyond any Tweet.

 

Win over generations

Your parents may have a Facebook account and might have dabbled with Twitter, but beyond their login information they can’t be bothered to use them. Social media is just a “neat” concept for them and all your wasted marketing efforts will hardly be worth the trouble.

 

Understand cultures

The way people communicate online can be deceiving, especially in the Arab region where more English than Arabic content is available, yet more Arabic content is in demand. Understanding how cultures share online is still not as clear as we might imagine.

 

Offer the full experience

Gimmicks, contents, games and puns are all exciting and creative features in a social media marketing campaign. But even Skittle’s Touch the Rainbow campaign didn’t deliver the full experience of the luscious candy. Certain offline marketing tactics will still have the upper hand when it comes to customer experience.

 

 

Do you think social media can replace all other forms of marketing one day?

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Is the Gold Bubble Reaching Its Climax?

No matter what happens, the price of gold will increase. If we have another wave of international banking failures and a deflationary collapse, gold will rise as investors flock to it as a safe haven. But if the economy recovers and we actually get inflation from all of the monetary stimulus unleashed by the Federal Reserve and European Central Bank, gold will rise as an inflation hedge. Apparently, there is no scenario under the sun in which gold won’t rise.

It all sounds great, of course. But this is precisely the kind of sentiment that breeds bubbles. Popular “can’t lose” investments always seem to have a way of losing money. You “couldn’t lose” buying tech stocks in the 1990s until you suddenly lost a bundle. Because of a shortage of coastal land, you “couldn’t lose” buying Miami condos either … until you did.It’s impossible to ever say what the “correct” price for gold is because there is no good criteria to measure its value. It pays no dividends or interest, it has no earnings and it has little in the way of industrial value. Nothing of actual value is created.So, without a proper measuring stick, we’re left with imperfect comparisons and a hodgepodge of anecdotal evidence. Still, the evidence we do have has suggested that gold has been forming a bubble for roughly the last year. Let us review:

• Gold has decoupled from other commodities such as crude oil, and this has accelerated in the past six months. The divergence that is most inexplicable is that between gold and platinum. Consider Figure 1. During the past six months, platinum prices have been most flat while gold has shot to the moon. Even more strangely, platinum is considered to be a more prestigious and valuable precious metal than gold (and also has more industrial uses), yet today their prices are almost identical. As I write this, gold is trading at $1,853 per ounce and platinum for $1,873 per ounce.

Figure 1

• Gold’s traditional use as jewelry appears to be in terminal decline. Consider Figure 2, which I originally included in an article I penned in January. Gold’s global use as jewelry has been cut nearly in half during the past decade, even as economic growth has been stellar in traditional gold-buying countries like India. Yet gold for “investment” has increased by a factor of 65. And remember, this data only goes through 2010. I’d love to see what the chart would look like were it updated for the recent investor stampede into gold.

Figure 2

When the underlying demand characteristics of an asset start to shift, look out. Condos in Miami got ludicrously expensive only when speculators began to flip them for profit with no intention of ever living in them. And it is worth mentioning the last time gold used for investment exceeded gold used for jewelry was 1980 — the year the last gold bubble burst.

• Central banks and governments have become net buyers again. It is surprising given that central banks tend to be run by cerebral Ivy League economists, but central bankers tend to be absolutely horrid market timers. They were massive sellers of gold when it traded for $250 per ounce. Yet according to the World Gold Council, central banks have collectively imported 198 tons of gold in the first half of 2011. Even two years ago they were collectively selling 450 tons a year.

In perhaps the highest-profile move, Venezuelan President Hugo Chavez ordered the country’s central bank to repatriate 211 of its 365 tons of gold reserves currently held in U.S., European, Canadian and Swiss institutions. Chavez also decided to nationalize Venezuela’s gold mines. While I believe in studying the investment decisions of financial gurus to gain insights, Hugo Chavez does not come to mind as a sage investor I’d like to follow. One might consider Mr. Chavez’s rather noisy appearance on the gold scene as a sign that it is time to make your exit.I could go on, but you get my point. The gold bubble appears to have reached the mania stage, and in its recent price spike it has started to go parabolic. I believe we might be seeing the final, spectacular blow-off top of the gold bubble taking shape. I could be wrong — or early — but gold would appear to be highly risky at this stage.If you still own it, good for you. You’ve had a good run. But recognize the gold bubble for what it is, and don’t get greedy. If past bubbles are any indication, when gold cracks, you had better look out below.Charles Lewis Sizemore, CFA

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What is the correlation between American stock prices and the value of the U.S. dollar?

The correlation between any two variables (or sets of variables) summarizes a relationship, whether or not there is any real-world connection between the two variables. The correlation coefficient will always be between -1 and +1. These two extremes are considered perfect correlations. A negative coefficient means that the two variables, or sets of variables, will move in opposite directions (if one variable increases, the other will decrease); a positive coefficient will mean that the two will move in the same direction (as one increases, the other will increase)

If we compare the US Dollar Index (USDX), an index that tracks the value of the U.S. dollar against six other major currencies, and the value of the Dow Jones Industrial Average (DJIA), Nasdaq and S&P 500 over a 20-year period, the correlation coefficient calculated for the USDX versus the DJIA, Nasdaq and S&P 500, is 0.35, 0.39 and 0.38, respectively. Note that all of the coefficients are positive, which means that as the value of the U.S. dollar increases, so do the stock indexes, but only by a certain amount. Notice also that each coefficient is below 0.4, which means that only about 35% to 40% of the stock indexes' movements are associated with the movement of the U.S. dollar.

A country’s currency can become more valuable in relation to the rest of the world in two main ways: when the amount of currency units available in the world market place is reduced (for example, when the Fed increases interest rates and causes a reduction in spending), or by an increase in the demand for that particular currency. The fact that an increase in the U.S. dollar affects the value of American stocks seems natural, as U.S. dollars are needed to purchase stocks. 

The value of American stocks, especially those that are included in market indexes, tend to increase along with the demand for U.S. dollars - in other words, they are positively correlated. One possible explanation for this relationship is foreign investment. As more and more investors put their money in  U.S. equities , they are required to first buy U.S. dollars, which can be used to purchase American stocks, causing the indexes to increase in value. 

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