Understanding Arbitrage: An Intuitive Approach to Financial Analysis [Hardcover]

Randall Billingsley (Author)

Book Description

Publication Date: October 15, 2005

Arbitrage is central both to corporate risk management and to a wide range of investment strategies. Thousands of financial executives, managers, and sophisticated investors want to understand it, but most books on arbitrage are far too abstract and technical to serve their needs. Billingsley addresses this untapped market with the first accessible and realistic guide to the concepts and modern practice of arbitrage. It relies on intuition, not advanced math: readers will find basic algebra sufficient to understand it and begin using its methods. The author starts with a lucid introduction to the fundamentals of arbitrage, including the Laws of One Price and One Expected Return. Using realistic examples, he shows how to identify assets and portfolios ripe for exploitation: mispriced commodities, securities, misvalued currencies; interest rate differences; and more. You'll learn how to establish relative prices between underlying stock, puts, calls, and 'riskless' securities like Treasury bills -- and how these techniques support derivatives pricing and hedging. Billingsley then illuminates options pricing, the heart of modern risk management and financial engineering. He concludes with an accessible introduction to the Nobel-winning Modigliani-Miller theory, and its use in analyzing capital structure.

Editorial Reviews

From the Back Cover

Arbitrage is central both to corporate risk management and to a wide range of investment strategies. Thousands of financial executives, managers, and sophisticated investors want to understand it, but most books on arbitrage are far too abstract and technical to serve their needs. Billingsley addresses this untapped market with the first accessible and realistic guide to the concepts and modern practice of arbitrage. It relies on intuition, not advanced math: readers will find basic algebra sufficient to understand it and begin using its methods. The author starts with a lucid introduction to the fundamentals of arbitrage, including the Laws of One Price and One Expected Return. Using realistic examples, he shows how to identify assets and portfolios ripe for exploitation: mispriced commodities, securities, misvalued currencies; interest rate differences; and more. You'll learn how to establish relative prices between underlying stock, puts, calls, and 'riskless' securities like Treasury bills -- and how these techniques support derivatives pricing and hedging. Billingsley then illuminates options pricing, the heart of modern risk management and financial engineering. He concludes with an accessible introduction to the Nobel-winning Modigliani-Miller theory, and its use in analyzing capital structure.

About the Author

Randall S. Billingsley, Ph.D., CFA is a finance professor at Virginia Tech as well as a Chartered Financial Analyst charterholder and holder of the Certified Rate of Return Analyst (CRRA) designation. He consults worldwide, and was

formerly Vice President at the Association for Investment Management and Research (now the CFA Institute). An award-winning teacher at both the undergraduate and graduate levels, he has taught review courses for CFA® charter candidates throughout the U.S. and Europe. His equity valuation case study was assigned in AIMR's Level II of the CFA® Curriculum. Billingsley serves as an expert witness on valuation and investment-related litigation.

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Product Details

• Hardcover: 224 pages
• Publisher: Wharton School Publishing (October 15, 2005)
• Language: English
• ISBN-10: 0131470205
• ISBN-13: 978-0131470200
• Product Dimensions: 9.3 x 6.2 x 1 inches
• Shipping Weight: 1.2 pounds
• Average Customer Review: 4.7 out of 5 stars  See all reviews (7 customer reviews)
• Amazon Best Sellers Rank: #364,789 in Books (See Top 100 in Books)

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Customer Reviews

Most Helpful Customer Reviews

14 of 14 people found the following review helpful:

5.0 out of 5 stars Well-known financial concepts, January 26, 2006

By 

Turgay BUGDACIGIL (Istanbul, Turkey) - See all my reviews

This review is from: Understanding Arbitrage: An Intuitive Approach to Financial Analysis (Hardcover)

“This book traces the common thread binding together much of financial thought – arbitrage. Distilled to its essence, arbitrage is about identifying mispricing and developing strategies to exploit it. An inherently simple concept – the act of exploiting different prices for the same asset or portfolio – arbitrage is as important as it is commonly misunderstood. This is because arbitrage is so often presented in financial arguments that are long on technical detail but short on economic intuition. Many business professionals’ exposure to the concept is limited to the media occasionally associating arbitrage with high-profile financiers, like foreign currency speculator George Soros, or former Secretary of the U.S. Treasury Robert Rubin, once head of arbitrage at Goldman Sachs. Yet such casual mentions do not convey the pervasive importance and usefulness of arbitrage in the world economy or in financial thought. Hence, the goal of this book is to emphasize the intuition of arbitrage and explain how it functions as a common thread in financial analysis. In so doing, I’ll provide concrete examples that illustrate arbitrage in action (from the Preface).”

In this context, Randall S. Billingsley divides this invaluable book into following seven chapters:

1. Arbitrage, Hedging, and the Law of One Price: This chapter explores the relationship between arbitrage, hedging, the Law of One Price, the Law of One Expected Return, and the structure of asset prices.

2. Arbitrage in Action: This chapter illustrates the nature of the Law of One Price, the Law of One Expected Return, arbitrage, and hedging using several examples. These concepts are first illustrated using the example of a discrepancy in the price of gold in two locations.

3. Cost of Carry Pricing: This chapter presents the cost of carry approach to identifying and exploiting mispriced positions. This useful, simple framework portrays the appropriate relationship between spot and forward or future prices. Properly priced forward/futures contracts reflect the cost and benefits of carrying a spot market commodity or security over time. The cost of carry model is illustrated in this chapter using the examples of a commodity, silver, and interest rates.


4. International Arbitrage: This chapter shows how arbitrage influences the relationship among currency exchange rates in light of international interest rate and inflation differences. Foreign exchange rates are structured by arbitrage pressures through international parity relations. Furthermore, this chapter describes various arbitrage strategies involving international interest rates and exchange rates.

5. Put-Call Parity and Arbitrage: This chapter presents the put-call parity relation, which relies on arbitrage to portray the relationship between call and put prices, the underlying stock price, the exercise price, the risk-free rate, and the time to expiration for European options. This chapter also shows how put-call parity lends insight into basic option/stock combination strategies such as the covered call and protective put.

6. Option Pricing: This chapter explains how arbitrage forms the backbone of modern option pricing.

7. Arbitrage and the (Ir)Relevance of Capital Structure: This chapter explains the role of arbitrage in assessing the relevance of capital structure decisions in the context of the Nobel Prize-winning Modigliani-Miller (M&M) theory. The chapter also shows how the firm may be viewed as put and call options and used the put-call parity framework to explain how a firm is valued from the distinct though linked perspectives of bondholders and stockholders.

Highly recommended

13 of 14 people found the following review helpful:

5.0 out of 5 stars Very helpful for someone looking for help in understanding how the principles of arbitrage are used to set prices, December 13, 2005

By 

Craig Matteson (Saline, MI) - See all my reviews
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This review is from: Understanding Arbitrage: An Intuitive Approach to Financial Analysis (Hardcover)

Arbitrage is one of those words that many people use with only a vague sense of what it means and the vague sense is too often wrong. Many believe it has to do with some kind of crooked speculation in the stock market. In reality, it is a very important idea that allows prices to be set for bonds, stocks, futures contracts, and all kinds of other things.

The basic idea is that if you could go into your local grocery store and see ketchup being actively purchased for $10 a bottle, but you could also buy it across the street for $2 a bottle, you would buy all the $2 bottles you could and take them across the street and sell them for $10. Of course, your bringing more supply might cause the grocery store to lower its price to compete with you. And the $2 store might notice their entire inventory walking out the door and therefore conclude that they can raise the price. This process would continue until both stores were selling the ketchup at nearly the same price. While this isn't pure arbitrage because I have to buy the ketchup first and have some risk of losing my inventory, the idea holds.

There should only be one price in the market for a given thing. However, for a variety of reasons, some of them still not completely understood, there are simultaneous mispricings that traders will seize on and simultaneously buy and sell the good to take advantage of the different prices and continue the trades until the prices again balance. For example, you do not expect to see $100 bills lying in the street. At one time or another you might see one and you would immediately pick it up. Then there would no longer be $100 bills in the street. The principle that you don't expect to see $100 bills in the street is similar to the idea that you should not see different prices for the same thing in the market. They might come along, but when they do they will instantly be traded away (usually by computers programmed to watch for them), so you shouldn't plan on making a living trading for them. However, being aware of the possibility might allow you see the odd $100 when it, rarely, is on the ground right in front of you.

However, the real purpose of knowing about arbitrage is more for learning about how to value equities, bonds, forward contracts, and futures. This book provides excellent supplementary material for a course in these subjects. General textbooks on the subject do cover the material, but rather quickly. Sometimes trying to get your mind around this stuff for the first time is like trying to draw looking in a mirror with someone waving her hands in front of your eyes.

Now, there are mathematical formulas in this book. That might lead some to wonder why the approach here is called intuitive. That is because what is provided here is given the reader as a tool for understanding the ideas. If you were to take a course in deriving and proving the material simply asserted here, well that is much heavier lifting. So, the reader does need to be able to read some basic math symbols such as delta and beta and some basic concepts along these lines. The author points the reader to glossaries and helps for those who need them.

So, this is NOT a book teaching you how to make a killing trading in arbitrage opportunities. It is a fine effort to help you understand why the market tends towards one price for a given thing and how those prices are derived. It is ideal for MBAs taking a course in this area and needing some extra help. However, the general reader interested in this subject can also find this very valuable.

15 of 17 people found the following review helpful:

5.0 out of 5 stars The Foundation of Fair Markets, November 8, 2005

By 

Craig L. Howe "The Pointed Pundit" (Darien, CT United States) - See all my reviews
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This review is from: Understanding Arbitrage: An Intuitive Approach to Financial Analysis (Hardcover)

Arbitrage is the foundation of fair financial markets. As a consumer, I become irritated when I find a product I have recently purchased, selling for less than I just paid. As an investor when the same thing happens, I feel cheated and question the validity of a system which allows such discrepancies to exist.

Arbitrage promotes market efficiency. In its essence, it identifies mispricings and develops strategies to exploit them. Yet, it is more. When understood in the classical sense, it provides the foundation for valuation. Randall S. Billingsley, a finance professor at Virginia Tech, weaves technical detail with intuitive financial thought to produce a well-written, easily understood discussion of how arbitrage relates to capital structure analysis.

In seven short chapters, he takes the reader on a sweeping tour of this age-old art and science of riskless, self-financing transactions. In his exploration of the topic, he:

1. Explores the core concepts in arbitrage analysis.
2. Illustrates the nature of arbitrage using several examples.
3. Introduces the concept of "cost-to-carry."
4. Shows how arbitrage influences currency exchange rates.
5. Explains put-call parity.
6. Reveals arbitrage as the foundation of option pricing.
7. Posits that despite financial claims, real assets determine a firm's value.

This book is a treasure. It will guide both professionals and students who wish to understand the often arcane concepts and mathematical foundation of arbitrage.