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+Chapter 27: Arbitrage 435 
+account. For example, suppose that an arbitrageur has $5 million in 3-month rever­
+sals at an effective rate of 10%. If he can buy $5 million worth of 3-month Certificates 
+of Deposit with a rate of 11 ½%, then he would lock in a profit of 1 ½% on his $5 mil­
+lion. This method of using paper to hedge rate fluctuations is not practiced by all 
+arbitrageurs; some think it is not worth it. They believe that by leaving the credit bal­
+ances to fluctuate at prevailing rates, they can make more if rates go up, and that will 
+cushion the effect when rates decline. 
+The third risk of reversal arbitrage is reception of an early assignment on the 
+short puts. This forces the arbitrageur to buy stock and incur a debit. Thus, the posi­
+tion does not earn as much interest as was originally assumed. If the assignment is 
+received early enough in the life of the reversal (recall that in-the-money puts can 
+be assigned very far in advance of expiration), the reversal could actually incur an 
+overall loss. Such early assignments normally occur during bearish markets. The only 
+advantage of this early assignment is that one is left with unhedged long calls; these 
+calls are well out-of-the-money and normally quite low-priced (¼ or less). If the 
+market should reverse and turn bullish before the expiration of the calls, the arbi­
+trageur may make money on them. There is no way to hedge completely against a 
+market decline, but it does help if the arbitrageur tries to establish reversals with the 
+call in-the-money and the put out-of-the-money. That, plus demanding a better 
+overall return for reversals near the strike, should help cushion the effects of the 
+bear market. 
+The final risk is the most common one, that of the stock closing exactly at the 
+strike at expiration. This presents the arbitrageur with a decision to make regarding 
+exercise of his long calls. Since the stock is exactly at the strike, he is not sure whether 
+he will be assigned on his short puts at expiration. The outcome is that he may end 
+up with an unhedged stock position on Monday morning after expiration. If the stock 
+should open on a gap, he could have a substantial loss that wipes out the profits of 
+many reversals. This risk of stock closing at the strike may seem minute, but it is not. 
+In the absence of any real buying or selling in the stock on expiration day, the process 
+of discounting will force a stock that is near the strike virtually right onto the strike. 
+Once it is near the strike, this risk materializes. 
+There are two basic scenarios that could occur to produce this unhedged stock 
+position. First, suppose one decides that he will not get put and he exercises his calls. 
+However, he was wrong and he does get put. He has bought double the amount of 
+stock - once via call exercise and again via put assignment. Thus, he will be long on 
+Monday morning. The other scenario produces the opposite effect. Suppose one 
+decides that he will get put and he decides not to exercise his calls. If he is wrong in 
+this case, he does not buy any stock - he didn't exercise nor did he get put. 
+Consequently, he will be short stock on Monday morning.