The paper "What Is the Significance for Financial Economics of the Concept of Arbitrage" is a great example of a finance and accounting assignment. Arbitrage is to identify mispricing and to establish stratagems to exploit it. Arbitrage is nothing but the act of exploring various prices for the same portfolio or asset. As per Stephen A Ross, one can make even a parrot as a knowledgeable political economist, but all it must have to comprehend are just two words: “ demand” and “ supply” (Ross 1976:341). To change a parrot as a knowledgeable financial economist is to make it to learn the sole word “ arbitrage” .
Arbitrage can be explained as the “ process of procurement of assets in one market and disposing it off in another market to gain profit from unjustifiable differences in prices” . (Ross 1976:341). It is to be noted that arbitrage is not only riskless but also remains as self-financing, which implies that the investor uses somebody’ s money (Ross 1976:341). The neoclassical theory of finance is footed upon the study of a) efficient markets, which means the markets that employ all available data in fixing price, b) the trade-off between risk and return, c) the principle of no-arbitrage and option pricing, d)corporate finance that is, the organisation of financial claims made by corporates.
(Ross 2008). As per Ross, neoclassical equilibrium efficiency connotes to Pareto efficiency, which means that there is no way available to enhance the well being of anyone individual without making someone worse off. If a capital market is efficient and competitive, then neoclassical reasoning suggests that the return that an investor anticipates to receive on an investment will be equivalent to the opportunity cost of employing the funds.
Thus, investing in a risky asset should offer some extra return as compared to riskless investment. The Arbitrage Pricing Theory (APT) Model assumes that an asset’ s anticipated return is impacted by a variety of risk factors, as contrasted to just market risk as adopted by the CAPM. The APT model expresses that the return on a security is linearly associated with H systematic risk elements. Nonetheless, the APT model does not indicate what the systematic risk elements are, but it is presumed that the relationship between the risk factors and asset returns is linear (Focardi & Fabozzi 2004:88).
List of References
Kerry Back (2006) A Course in Derivative Securities. Introduction to Theory and Computation New York: Springer Science and Business Media; p.13
Bodie (2008) Financial Economics New Delhi: Pearson Education India;p.228
Mary Buffett & David Clark (2011) Warren Buffett and the Art of Stock Arbitrage New York: Simon & Schuster;p.4
David Ellerman (2000) Towards an Arbitrage Interpretation of Optimization Theory New York : World Bank Publications
Sergio M Focardi & Frank J Fabozzi, FJ.(2004). The Mathematics of Financial Modelling and Investment . New York : John Wiley & Sons;p.88
Keith M Moore (1999) Risk Arbitrage: An Investor’s Guide. New York: John Wiley & Sons ; p.10
Billingsley Randall & Randall S Billingsley (2005) Understanding Arbitrage: An intuitive Approach to Financial Analysis. New Delhi: Pearson Education India;p.7
Stephen A Ross (1976) The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory 13(3) 341-360.