In so far as this sum pertains to a potential loss in lending, it belongs to the realm of credit. In so far it is bought and sold as a commodity with fluctuating price, it is in the realm of market. It is in the latter capacity that it becomes the subject of arbitrage. If, for example, the price of this "$5 value" rises to $6, Arbitraguer would create a riskless position by:
• Selling the call for $6 (+$6)Numbers in parenthesis show the amount of direction of the cash flow, with “+” for inflow. The strategy yields $1 net income no matter what the future stock price, as shown below:
• Borrowing $20 (+$20)
• Buying ½ share of stock at $25 (– $25)
If stock is $60:
• Sell ½ shares for $30 (+30)
• Pay back the $20 debt (– $20)
• Pay $10 to call holder (– $10)
Keep the $1 net income.
If stock is $40:
• Sell ½ shares for $20 (+$20)
• Pay back the $20 debt (–$20)
• Option expires worthless
Keep the $1 net income
The idea of “$5 value” being bought and sold in the market for more or less than $5 might seem counter-intuitive. But that is precisely what commoditization entails: subjecting a product with a definite value to the supply and demand of sellers and buyers, only in the case of a “financial product” all attributes of utility are stripped away so that “value” alone remains.
The “$5 value” trades for more or less than $5 due to the transformation of values to prices. This subject is beyond our discussion. Suffice it to say that the phenomenon takes place millions of times each day in every sphere of economic life. A man who spends $300,000 on land, $200,000 on labor and $500,000 on material to build a 1-million dollar house and receives an offer for only $800,000 is experiencing this law, which to him appears as “lack of demand.”
The “fair value” of financial products is derived under such grotesquely distorting assumptions. But when presented to the market, the product must come down to earth. It must incorporate, however imperceptibly or crudely, the actual conditions of the market into its price structure. It must pay for the sins of the imperfect theory from which it is born by shedding its value. Thus, its theoretical and idealized value is turned into market price. (Nasser Saber, Speculative Capital. Vol. 1)
The more complicated a financial product in terms of cash flows and covenants, the more severe its value-to-price adjustment and the more complicated the mode of the adjustment. In the Summer of ’07, CDOs provided a graphic example of this complexity. As a series of credit events materialized, the equity piece of CDOs suffered but the AAA tranche retained its price. Then came one additional event, no more significant than others, and the entire price CDO collapsed. With their practical acumen, traders termed this the “cliff risk,” a vivid example of the dialectical principle of the accumulation of quantitative changes resulting in a qualitative change.
Note the critical interplay that is set in motion by the actions of Arbitrageur: Lender, Option Player and Arbitrageur are now “linked” through a process that puts a value on the default and then makes it the subject of trading. That is how – through this commoditization driven by Arbitrageur’s search for riskless profit – speculative capital makes credit “game”.
