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I have a quick question about how arbitrage works. Let's say that there are two investments:

  1. Invest in a two-year zero
  2. 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.

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Hi: Don't think of a specific case. Just think of investment A and investment B and assume that the return on both investments is the same. Also, assume that investment A costs more to invest in than investment B. In that case, you would sell some amount, X, of investment A to Mr. Pushover and buy the same amount, X, of investment B with the proceeds from Mr. Pushover ( and you'll have a little left over since A costs more than B. Call what's left, L, for leftover ).

Then, when the investment horizon is complete, you pay Mr. Pushover the return with the return that you made from investing in B.

But, now you still have L left so you made L with no risk. That's the arbitrage. I hope that helps. To summarize, if two investments return the same thing, they have to cost the same thing or else there's an arbitrage.

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