Direct questions and comments to: Glossary master
Type-1 Arbitrage is a trading strategy that generates a strictly positive cash flow between 0 and T in at least one state with positive probability and does not require an outflow of funds at any date, that is a trading strategy that produces something from nothing. A simple example of this kind of arbitrage is the opportunity to borrow and lend at two different rates of interest.
Type-2 Arbitrage generates a net future cash flow of at least zero for sure, with the arbitrageur getting his profits up front. This kind of arbitrage is referred to as free lunch. The simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices may illustrate this case.
This text-book definition of arbitrage requires no capital and entails no risk. We do not expect such strategies to exist in the equilibrium state of efficient securities market.
See also: efficient capital market, equilibrium
Literature: Blume & Siegel (1992), Fama (1970)
| Entry by: Eva Kramer |
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November 17, 1997 Direct questions and comments to: Glossary master |
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