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KackToodles
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January 15th, 2007, 8:30 pm

QuoteOriginally posted by: torontosimpleguyArbitrage is a driving force behind Black-Scholes theory. If you don't believe in Black-Scholes formula what are you doing here? You obviously a dumb student who doesn't understand the arbitrage principle and why it applies to BS and not other things. Arbitrage in your dream world doesn't even work for bonds, why should it work for equities?
Last edited by KackToodles on January 14th, 2007, 11:00 pm, edited 1 time in total.
 
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torontosimpleguy
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January 15th, 2007, 8:35 pm

QuoteOriginally posted by: KackToodlesYou obviously a dumb student who doesn't understand the arbitrage principle and why it applies to BS and not other things. Arbitrage in your dream world doesn't even work for bonds, why should it work for equities?Thank you. Arbitrage works everywhere. I recommend you to read Baxter & Rennie's 'Financial Calculus', which nicely explains the subject.
 
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gardener3
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January 15th, 2007, 8:36 pm

QuoteOriginally posted by: torontosimpleguyTraditional definition: Arbitrageurs are those who exploit market inefficiencies and make money without initial investment.Making riskless money on stock forwards doesn't require knowledge of stock fundamentals at all.We are talking about the future value of the underlying. Suppose you have two traders and one has more information or has done techincal analysis which suggests that the underlying will go down in the future. The forward price is still determined by arbitrage, but the informed tarder will make money, and the other will lose money. Two different concepts.
 
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yabbadabba
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January 15th, 2007, 8:38 pm

That is exactly what I'm saying. BF says: arbs are those who know the fundamental value and trade the spread to the current price, which is not very logical.To repeat these are the models in Shleifer's book: Noise Trader Model (NTM), Professional Arbitrage Model (PAM), Model of Investor Sentiment (MIS) and Positive Feedback Model (PFM). NTM and PAM are mostly of theoretical interest, whereas MIS and PFM are more applicable for traders.
 
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torontosimpleguy
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January 15th, 2007, 8:41 pm

QuoteOriginally posted by: gardener3We are talking about the future value of the underlying. Suppose you have two traders and one has more information or has done techincal analysis which suggests that the underlying will go down in the future. The forward price is still determined by arbitrage, but the informed tarder will make money, and the other will lose money. Two different concepts.Yup, I know this.
 
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gardener3
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January 15th, 2007, 8:43 pm

QuoteOriginally posted by: torontosimpleguyQuoteOriginally posted by: KackToodlesYou obviously a dumb student who doesn't understand the arbitrage principle and why it applies to BS and not other things. Arbitrage in your dream world doesn't even work for bonds, why should it work for equities?Thank you. Arbitrage works everywhere. I recommend you to read Baxter & Rennie's 'Financial Calculus', which nicely explains the subject.Arbitrage does not work everywhere. There are limits. See the Barberis and Thaler paper you have cited for specific reasons and examples.
 
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torontosimpleguy
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January 15th, 2007, 8:48 pm

QuoteOriginally posted by: yabbadabbaBF says: arbs are those who know the fundamental value and trade the spread to the current price, which is not very logical.I still don't agree but it's OK.Arbitrageurs don't have to know the fundamental values since they don't hold position on a stock.
 
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torontosimpleguy
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January 15th, 2007, 8:53 pm

QuoteOriginally posted by: gardener3Arbitrage does not work everywhere. There are limits. See the Barberis and Thaler paper you have cited for specific reasons and examples.I don't want to buy it. I have some extracts. Do you have a copy?
 
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KackToodles
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January 15th, 2007, 11:23 pm

QuoteOriginally posted by: torontosimpleguyI still don't agree but it's OK.Friend, use your common sense. If arbitrage works, then 90% of wall streeters would be out of a job. They would just have computers spit out the value of every stock using a B/S formula. There would be no speculation. Why hire thousands and thousands of fast talking financial analysts? Why are so many people "speculating" on the market? How can certain people like Buffett or Soros get rich? How can there be an Internet stock bubble?
 
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torontosimpleguy
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January 16th, 2007, 2:35 am

Guys, I see you don't understand the very basics of finance.What is the difference between investors and arbitrageurs in a moneymaking process?
 
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sunzhoujian
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January 16th, 2007, 5:53 am

Good post. You must have been in this field for many years.
 
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yabbadabba
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January 16th, 2007, 6:33 am

QuoteOriginally posted by: torontosimpleguyGuys, I see you don't understand the very basics of finance.What is the difference between investors and arbitrageurs in a moneymaking process?Hello,would you mind reading my posts? There is no such things as basics, because even nobel prize winners contradict each other. Obviously there are no easy answers.QuoteWhy hire thousands and thousands of fast talking financial analysts? Why are so many people "speculating" on the market? How can certain people like Buffett or Soros get rich? How can there be an Internet stock bubble? The Positive Feedback Model tries to explain bubbles. Soros explains his success in alchemy of finance. But analysists and most of investment mainstream don't read these kind of books, because they think the market is efficient. That is why arbitrage works, but not all people do arbitrage.
 
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UnderTheRadar
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January 16th, 2007, 12:25 pm

Kack Toodles, what do you mean arbitage does not apply to equities??? Of course arbitrage applies to equities. Index vs futures. Or individual components vs physical index....Arbitrage and spanning are related however you cannot say that arbitrage does not apply to equities just because spanning securities does not work on stock price processes in a BS option pricing framework. Arbitrage (in its many forms) does apply to equities.
 
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flairplay
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January 16th, 2007, 12:35 pm

QuoteOriginally posted by: Traden4AlphaQuoteOriginally posted by: torontosimpleguyThere are 2 types of traders - rational traders (they trade based on fundamentals) and noise traders (they trade based on "irrationals").Whoa. Whoa. Whoa. That's an interesting pair of labels. Isn't fairer to say that traders that only use the fundamentals are also "irrational" because they ignore key information and causal relationships in the markets (the fact that other market participants can and do react to price and price changes). Using only the fundamentals to estimate price assumes that all other participants use only the fundamentals to estimate price.One could similarly argue that technical analysts are also irrational if they ignore the fundamentals.Spot on.All this debate between just fundamentals and technicals ignores causal relationships. The degree of stochasticity is subjective depending on your information set and understanding of causal relationships.Even fundamental analysis does not lay too much emphasis on causal relationships. It's far too vague and easily rationalised by post hoc arguments and twists.
 
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Traden4Alpha
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January 16th, 2007, 12:51 pm

QuoteOriginally posted by: torontosimpleguyI absolutely disagree.Simple example: Why is the price of forward determined by the market based on fundamental analysis and not on technical analysis?Here is the key economic point - market is driven by arbitrage.Are the prices of forwards NEVER significantly out of line with the fundamentals? As an aside, there are reasons why some instruments (e.g., derivatives) are less prone to BF/technical effects than others. Having a set near-term expiration or contract date bounds the trading dynamics because, at some fixed date, the market reveals the true answer to the value of the instrument -- KackToodles called that a spanning . Even so, experiments show that people will push a market to "irrational" prices even with a fixed end date because they have some means to both make money and resell the mispriced instrument to a greater fool. Equities offer the greatest room for BF/TA. As Yabbadabba said, with equities there's rarely a final revelation of the true value of the company (acquisitions and bankruptcies might be the exception). This lack of a horizon for equities leaves traders playing the game of "what do I think that other traders think that other traders think that other traders .... think the price will be." -- its Keynes' beauty contest. Some equities traders (pairs traders) try to impose an arbitrage-like relationship between related stocks, but the transactions aren't risk-free because the two companies often do differ in ways that lead to divergence.Yes, "arbitrage" is a driver (with some exceptions) especially for derivatives. The key is that the word "arbitrage" says nothing about why one instrument is mispriced in one market at one time with respect to the same/similar/different instrument in the same/different market at the same/different time. Nor does it why the prices will converge. Nor does it discuss the people that profit from the divergence. Non-fundamental factors (BF, persistent bias in participants models or information, belief in momentum, herding, etc.) can create price differentials now and in the future. The lack of timely convergence of prices, which has blown-up more than its share of traders with an excessive belief in the fundamentals, can be a rational response by other traders in the market. If one trader knows that another trader is over-invested in some arbitrage transaction, the first trader can profit at the arbitrageur's expense. (And then there's the problem of flaws in arbitrageur's models -- before 1987 there was no volatility smile because that was irrational under BS)There are also exceptions to the arbitrage-is-driver (even the profit-is-driver) rule with the presence of non-financial influences on decision makers. Fund managers and institutional investors are, strictly speaking, concerned with more than maximizing financial return versus risk. They also have a strong, possibly dominant, motivation to keep their jobs. Clients don't punish mistakes by fund managers if the fund manager makes the same mistake as other fund managers. On the other hand, clients do punish even minor transgressions by iconoclasts. (that's probably another issue that a broader treatment of a-rationality would consider - that participants utility functions include non-financial considerations that bias trading)