The Hindu Business Line : Role of arbitrage in derivatives

ALL pricing of derivatives is done by arbitrage, and by arbitrage alone. In other words, basic economics dictates a relationship between the price of the spot and the price of a futures. If this relationship is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price reverts to its economic value.

In this sense, arbitrage is basic to pricing of derivatives. Without arbitrage, there would be no market efficiency in the derivatives market: prices would stray away from fair value all the time. Indeed, a basic fact about derivatives is that the market efficiency of the derivatives market is inversely proportional to the transactions costs faced by arbitrageurs in that market.

When arbitrage is effective, market efficiency is obtained, which improves the attractiveness of the derivatives from the viewpoint of users such as hedgers or speculators.

In most countries, there are bigger arbitrage opportunities in the early days of the futures market. As larger resources and greater skills get brought into the arbitrage business, these opportunities tend to vanish.

India is better placed in terms of skills in arbitrage, as compared with many other countries, thanks to years of experience with line operators who are used to doing arbitrage between exchanges. These kinds of traders would be easily able to redirect their skills into this new market. These operators are familiar with a host of real-world difficulties, such as different expiration dates on different exchanges, bad paper, etc.

Queries relating to futures/options may be mailed to

fno@thehindu.co.in

or to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002.

(extracted from nseindia.com)

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