Arbitrage, in the context of MM (Modigliani-Miller), refers to a strategy that exploits price discrepancies between two securities with identical cash flows. MM theory states that in a perfect market, arbitrage opportunities should not exist.
The Key Principle: MM's arbitrage argument posits that investors can create a portfolio of securities that perfectly replicates the cash flows of another security, but at a lower cost. This strategy, known as arbitrage, allows investors to profit from the price difference without taking on any additional risk.
Practical Example: Imagine two companies, A and B, with identical business operations and future cash flows. However, Company A's stock is trading at a lower price than Company B's stock. An arbitrageur could buy shares of Company A and simultaneously sell short shares of Company B. The arbitrageur would profit from the price difference between the two stocks, as the cash flows from both companies would perfectly offset each other.
MM's Implications: The existence of arbitrage opportunities contradicts MM's core propositions. If arbitrage opportunities exist, it implies that the market is not perfectly efficient. The existence of such opportunities would lead to market forces that would eventually eliminate the price discrepancies, driving the prices of the two securities to converge.
In Summary: Arbitrage, according to MM, is a strategy that exploits mispricing in the market. The existence of arbitrage opportunities contradicts MM's theory of perfect capital markets.
