Arbitrage

In its strictest definition, arbitrage is defined as the activity of buying and selling a portfolio or collection of assets that provides a guaranteed, or riskless, cash flow when the present total cost of the portfolio is zero or less. Note that a positive cost for an asset suggests a cash outflow so that a negative cost would be considered a cash inflow.

In a simplified world where there are two dates for cash flows to change hands, today and some future date that we shall call tomorrow, there are two types of arbitrage that may occur:

• 1.
  Where a nonpositive investment occurs today (someone pays you today or gives you the rights to own the portfolio), which then produces a guaranteed positive cash flow tomorrow
• 2.
  Where ...