Derivative: Arbitrageur’s Rule

CFA Level II Derivatives
#1

Hello,

The CFAI book says that " If we sell the underlying, we lend the money." How do we lend money if we are selling the underlying?

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The arbitrageur abides by two fundamental rules:

  1. Rule #1 Do not use your own money.
  2. Rule #2 Do not take any price risk.

The arbitrageur often needs to borrow or lend money to satisfy Rule #1. If we buy the underlying, we borrow the money. If we sell the underlying, we lend the money. These transactions will synthetically create the identical cash flows to a particular forward commitment, but they will be opposite and, therefore, offsetting, which satisfies Rule #2. Note that for Rule #2, the concern is only market price risk related to the underlying and the derivatives used, as explained in detail later.

Thanks

#2

Howdy.

When we sell it we get cash. We use that cash to buy a risk-free bond.