A gap between a quoted forward and its frictionless value is a trading opportunity only if the required legs can be executed and funded. Bid–ask spreads, borrow constraints and interim margin calls can prevent a desk from capturing the gap. This lesson builds an executable price band and distinguishes arbitrage from a risky relative-value trade.
Learning objectives. By the end of this note you should be able to:
- restate the law of one price and the cash-and-carry / reverse cash-and-carry trades;
- decompose an apparent mispricing into a no-arbitrage band created by costs and constraints;
- explain funding liquidity versus market liquidity and how margin calls create feedback;
- describe horizon risk (noise-trader / margin spiral risk) for capital-constrained arbitrageurs;
- interpret persistent CIP basis and index futures dislocations with this toolkit.
In this lesson
- Law of one price and replication (recap)
- Transaction costs and the no-arbitrage band
- Funding constraints and margin
- Horizon risk and limits to arbitrage
- Covered interest parity after 2008
- Consumption assets: inequality, not failure
- Practical checklist before calling "arb"
Before you start
- Funding, Margin, Collateral and Short Selling
- Forwards, Futures and Swaps
- The Law of One Price and Replication: No-Arbitrage Pricing from First Principles
The full lesson, with worked examples and exercise solutions, is for members.
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