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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