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.