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