Please explain the technique of Stock arbitration and hedging.?

Answer 1

It isn't 'arbitration' it is 'arbitrage.'

In theory, there should be no arbitrage profits -- which means 'riskless profits.' In fact, though, there are sometimes mispricings of securities so that you could buy an asset and then short or sell a portfolio of securities so that the cash flows exactly cancel out & make a profit.

Let's look at an example. Suppose that you own a five year treasury bond worth $100,000. Now, suppose that you have an opportunity to sell it and buy a five year corporate bond with the same cash flows for $90,000. The reason that the corporate bond is cheaper is that the company could default on its payments. But you can buy a Credit Derivative that is something like insurance. You pay them a certain amount every quarter, and if the bond defaults, they pay you $100,000. Let's suppose that the present value of this is $8,000. In this case, you sold one bond and bought two securities that give you the same cash flows and made $2,000 without changing the level of risk. The cash you took out is called an arbitrage profit.

Hedging is the act of making an investment to lessen or eliminate the risk of another security. For example, a bond trader may be asked to purchase a $100MM portfolio from a client. He makes money by selling these bonds at a slightly higher price than he bought them at. But it might take him a week or two to unwind the position. If interest rates suddenly jump up, what can he do?

He enters into a hedge to eliminate some of the interest rate risk. Perhaps he sells interest rate futures. If rates go up, he loses money on the bonds in inventory but makes money on the futures contract. If rates go down, he makes money on the inventory but loses on the futures contract. He wants to sell enough futures to minimize his losses.

He could also do a partial hedge & buy interest rate options. In this case, the options pay off if he loses money on his investment -- but he gets to keep his money if the investment (inventory) gains money. Because he never loses money on the payoff of the option, he has to pay a fee for entering this contract.

Hedging is an important way to manage risk -- and may be beneficial to both parties. A farmer who grows corn may be worried that corn prices will drop after the harvest. He would like to lock in a price now. General Mills needs corn in the Fall, and may be worried about prices increasing after the harvest. They might want to lock in prices now, too -- and enter into a forward contract with the farmer to buy his crop at a set price.

Answer 2

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