I have a quick question about how arbitrage works. Let's say that there are two investments:
- Invest in a two-year zero
- Invest in a one-year zero and then reinvest into a forward contract from year one to year two.
The no arbitrage principle theoretically states that since one could make unlimited money, these two investment strategies must be priced equally.
I am a little confused as to how one would take advantage of this arbitrage opportunity. Suppose investment 2 costs more than investment 1. I suppose I would have to somehow borrow money and sell investment 2, take that money and put it in investment 1, and then pay back investment 2? I'm really not sure who I would be borrowing from and how I would be able to sell. If someone could give me a step-by-step process on how to take advantage of a hypothetical arbitrage opportunity, that would be greatly appreciated.