This paper examines the risk and return of the so-called capital structure arbitrage, which exploits the mispricing between a company’s debt and equity. Specifically, a structural model provides a connection between a company’s equity price and its credit default swap (CDS) spread. Based on the deviation of CDS market quotes from their theoretical counterparts, a convergence-type trading strate...

This paper studies hidden arbitrage opportunities in markets where large traders affect the price process, and where the market is complete (in the classical sense). The arbitrage opportunities are “hidden” because they occur on a small set of times (typically of Lebesgue measure zero). These arbitrage opportunities occur naturally in markets where a large trader supports the price of some asse...

In this paper, installment options on the underlying asset which evolves according to Black-Scholes model and pays constant dividend to its owner will be considered. Applying arbitrage pricing theory, the non-homogeneous parabolic partial differential equation governing the value of installment option is derived. Then, penalty method is used to value the European continuous installment call opt...

We consider a securities market with bid–ask spreads at any period, including liquidation. Although the minimum-cost super-replication problem is non-linear, we introduce an auxiliary problem that allows us to characterize no-arbitrage via linear programming techniques. We introduce the notion of effective new security and show that effectiveness restricts the no-arbitrage bid and ask prices of...

The predominant explanation for arbitrage crashes is a lack of investor capital to exploit mispricing. This paper shows that slow moving capital is only partially responsible for the 2005 and 2008 arbitrage crashes in the convertible bond market. Even when convertible bonds where underpriced, investors were still buying strictly dominated straight bonds from the same issuers. This finding sugge...

We consider a securities market with bid-ask spreads at any period, including liquidation. Although the minimum-cost super-replication problem is non-linear, we introduce an auxiliary problem that allows us to characterize no-arbitrage via linear programming techniques. We introduce the notion of e¤ective new security and show that e¤ectiveness restricts the no-arbitrage bid and ask prices of a...

The overlapping expectations and the collective absence of arbitrage conditions introduced in the economic literature to insure existence of Pareto optima and equilibria with short-selling when investors have a single belief about future returns, is reconsidered. Investors use measures of risk. The overlapping sets of priors and the Pareto equilibrium conditions introduced by Heath and Ku for c...

A prediction market is a relatively new form of financial market whose ultimate purpose is to predict the outcome of an uncertain future event. This paper examines the extent of arbitrage in prediction markets and its implications for market efficiency. The most straightforward arbitrage opportunity in prediction markets is to exploit any divergence of the aggregate price of binary contracts pr...

Abstract To understand deviations from covered interest parity (CIP), it is crucial to account for heterogeneity in funding costs across both banks and currency areas. For most market participants, the no-arbitrage relation holds fairly well when implemented using marginal risk-free investment instruments. However, a few high-rated do enjoy CIP-arbitrage opportunities. Dealers avert inventory i...

We prove a version of the Fundamental Theorem of Asset Pricing, which applies to Kabanov’s approach to foreign exchange markets under transaction costs. The financial market is modelled by a d × d matrix-valued stochastic process (Σt)t=0 specifying the mutual bid and ask prices between d assets. We introduce the notion of “robust no arbitrage”, which is a version of the no arbitrage concept, ro...