Not to be confused with Arbitration. The term is mechanics of forex trading applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Arbitrage” is a French word and denotes a decision by an arbitrator or arbitration tribunal. If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium, or arbitrage-free market.
An arbitrage equilibrium is a precondition for a general economic equilibrium. This refers to the method of valuing a coupon-bearing financial instrument by discounting its future cash flows by multiple discount rates. By doing so, a more accurate price can be obtained than if the price is calculated with a present-value pricing approach. Arbitrage-free pricing is used for bond valuation and to detect arbitrage opportunities for investors.
For the purpose of valuing the price of a bond, its cash flows can each be thought of as packets of incremental cash flows with a large packet upon maturity, being the principal. Since the cash flows are dispersed throughout future periods, they must be discounted back to the present. In the present-value approach, the cash flows are discounted with one discount rate to find the price of the bond. In arbitrage-free pricing, multiple discount rates are used.
The present-value approach assumes that the yield of the bond will stay the same until maturity. This is a simplified model because interest rates may fluctuate in the future, which in turn affects the yield on the bond. The discount rate may be different for each of the cash flows for this reason. Each cash flow can be considered a zero-coupon instrument that pays one payment upon maturity.