Editing Rational pricing (section)

==Arbitrage mechanics==<!-- This section is linked from [[Arbitrage]] -->
[[Arbitrage]] is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. Where this mismatch can be exploited (i.e. after transaction costs, storage costs, transport costs, dividends etc.) the arbitrageur can "lock in" a risk-free profit by purchasing and selling simultaneously in both markets.

In general, arbitrage ensures that "the [[law of one price]]" will hold; arbitrage also equalises the prices of assets with identical cash flows, and sets the price of assets with known future cash flows.

===The law of one price===
The same asset must trade at the same price on all markets ("the [[law of one price]]").
Where this is not true, the arbitrageur will:
# buy the asset on the market where it has the lower price, and simultaneously sell it ([[short selling|short]]) on the second market at the higher price
# deliver the asset to the buyer and receive that higher price
# pay the seller on the cheaper market with the proceeds and pocket the difference.

===Assets with identical cash flows===
Two assets with identical cash flows must trade at the same price. Where this is not true, the arbitrageur will:
# sell the asset with the higher price ([[short selling|short sell]]) and simultaneously buy the asset with the lower price
# fund his purchase of the cheaper asset with the proceeds from the sale of the expensive asset and pocket the difference
# deliver on his obligations to the buyer of the expensive asset, using the cash flows from the cheaper asset.

===An asset with a known future-price===
An asset with a known price in the future must today trade at that price [[discounting|discount]]ed at the [[Risk-free interest rate|risk free rate]].

Note that this condition can be viewed as an application of the above, where the two assets in question are the asset to be delivered and the risk free asset.

(a) where the discounted future price is ''higher'' than today's price:
# The arbitrageur agrees to deliver the asset on the future date (i.e. [[Forward contract|sells forward]]) and simultaneously buys it today with borrowed money.
# On the delivery date, the arbitrageur hands over the underlying, and receives the agreed price.
# He then repays the lender the borrowed amount plus interest.
# The difference between the agreed price and the amount repaid (i.e. owed) is the arbitrage profit.

(b) where the discounted future price is ''lower'' than today's price:
# The arbitrageur agrees to pay for the asset on the future date (i.e. [[Forward contract|buys forward]]) and simultaneously sells ([[Short selling|short]]) the underlying today; he invests (or banks) the proceeds.
# On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate.
# He then takes delivery of the underlying and pays the agreed price using the matured investment.
# The difference between the maturity value and the agreed price is the arbitrage profit.

Point (b) is only possible for those holding the asset but not needing it until the future date.  There may be few such parties if short-term demand exceeds supply, leading to [[backwardation]].