Use of Hedging

The term arbitrage refers to purchases in one market, and sales in another market which, together, have the effect of maintaining the prices of comparable items traded in the affected markets within the limits defined by the cost of buying the items in one market and selling them in another (Rees, 1991, 37). Thus, it can be seen, at once, that the use of arbitrage is a method of limiting riskof establishing the boundaries, so to speak, of risk.

Arbitrage transactions, by definition, are either simultaneous, or nearly so; thus, the conduct of arbitrage activities tends to maintain prices in different markets for similar items within a reasonable alignmentwithin the arbitrage limits (Welshans and Melicher, 1990, 402). Although the principal effect of arbitrage transactions is to bring about a relation among prices of similar items according to the cost of converting the items from one to the other (between markets), there need not be certainty about the outcome (Rees, 1991, 38).

The absence of certainty in arbitrage transactions is illustrated in the following example, which involves the use of the principle of arbitrage in equity stock market activity. Assume

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in the puts and calls options market, they are simply speculators who are creating risk where none previously existed (Brealey and Myers, 1991, 458459). Where hedging is used by producers, traders, and speculators as either a protection against or as a means of exploiting future price changes, arbitrage is used by either the owners of items or by speculators to protect against or as a means of exploiting existing price differentials in two or more markets. As is true with hedging, arbitrage may be used either for the purpose of limiting risk or for the purpose of making a speculative profit. Either concept may be applied in a socially useful manner by producers, traders, or owners of items, or in a manner of dubious social worth by the speculators who create risk, rather than limit risk. It has been said that arbitrage in itself is not speculative (Rees, 1991, 20), However, as the preceding illustrations have demonstrated, both arbitrage and hedging may be applied in ways which enhance speculative activities. A form of arbitrage occurs when a merchant acquires a stock of a specific commodity at a given spot price, sells an equal quantity of the specific commodity forward, and, as a result of such transactions (and many othe
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Approximate Word count = 3136
Approximate Pages = 13 (250 words per page)

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