economics terms

Arbitrage Pricing

Arbitrage pricing determines the market price of financial securities given a risk-free "bank" that takes deposits and lends at a known interest rate.

Assumptions:  Bond A pays a risk-free $1000 in one year.  Banks take deposits and make loans at a 10% interest rate.

Case 1:  The bond currently sells for $900.  To secure immediate arbitrage profits, borrow 1000/1.10 = 909.09.  Buy the bond, and put a 9.09 arbitrage profit in your pocket.  In one year, you will receive 1000 from the bond, which will pay off what you owe the bank.

Case 2:  The bond currently sells for $920.  To secure an immediate arbitrage profit, sell bonds at 920.  Put 909.09 of the proceeds in the bank at 10%, and put a 10.91 arbitrage profit in your pocket.  In one year, your bank account will contain 1000, which will just pay off the bondholder. 

The arbitrage profit opportunity will exist unless the bond sells for $909.09.  If the bank interest rate is fixed, efforts to secure infinite arbitrage profits will very quickly push the bond price to $909.09.

See arbitrage profit.

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Economics Terms

Arbitrage Pricing
Arbitrage Profit
Average Cost
Balance of Payments
Budget Constraint
Call Option
Concave Function
Consumer Surplus
Consumption Function
Convex Function
Deadweight Loss
Demand Curve
Economic Agent
Economic Model
Economics Textbook
Endogenous Technical Change
Exchange Rate
Expectations Hypothesis
Federal Funds (Fed Funds) Rate
Fixed Exchange Rate
Floating Exchange Rate
Frictional Unemployment
Gross Domestic Product (GDP)
Income Effect
Income Elasticity
Indifference Curve
Interest Rate
Intertemporal Substitution
Jensen's Inequality
Marginal Cost
Marginal Product
Marginal Utility
Optimizing Behavior
Perfect Competition
Phillips Curve
Price Elasticity
Producer Surplus
Production Function
Production Possibility Frontier
Put Option
Reservation Wage Rate
Risk Aversion
Structural Unemployment
Substitution Effect
Supply Curve
Taylor Rule
Technological Growth
Term Structure
Theory of the Consumer
Theory of the Firm
Unemployment Rate
Utility Function
Velocity of Money
Yield Curve