tecno123: Profiting from Inconsistent Probabilities and Pairs Arbitrage Trading

PROFITING FROM INCONSISTENT PROBABILITIES

Suppose that:

If event E occurs, the value of two assets, A and B, will both rise.

The price of asset A reflects a higher probability of occurring of event E than the price of asset B, and thus inconsistent probabilities exist.

Now if all else equal, asset A is overvalued compared to asset B.

How;

If event E does occur, the price of asset A will not rise as much as the price of asset B.

This is because the occurrence of event E is mostly incorporated in the price of asset A that’s why the price of stock A is overvalued. Since the probability of occurrence of event E in the case of stock B is low; it means there is still a chance for a rise in price of stock B, so that stock B is undervalued and an opportunity is available for the investors to buy stock B.

If event E does not occur, the prices of both the assets will fall, but the price of asset A will decline more than the price of asset B.

Compared with asset B, the price of asset A understates the probability that event E may not occur.

How to generate profit from Inconsistent Probabilities?

Investors can make profits by buying undervalued asset (i.e. B) and selling overvalued asset (i.e. A)

Conservative investors will buy asset B and reduce or fully liquidate their position in asset A.

Aggressive investors will buy asset B and short asset A.

This strategy is known as a “pairs arbitrage trade”, which involves using the proceeds from the short sale of one stock to buy another.

Therefore, to profit from Inconsistent Probabilities, investors should buy asset A and sell asset B.

Note that the above discussion is based on the assumption that the occurrence of event E will increase the values of tow assets, A & B

If the occurrence of event E will reduce the value of assets A & B, asset B will be overvalued if compared with asset A.

Example

Suppose that:

If a hike in oil price occurs, the stock prices of American Airlines (AA) and British Airways (BA) will decline.

The stock price of AA reflects a 0.70 probability of a hike in oil price; where as the stock price of BA reflects a 0.40 probability of a hike in oil price.

In this situation, the stock price of BA is overvalued if compared to the stock price of AA.

A conservative investor can profit by taking a long position in the stock of AA andreducing or eliminating or liquidating his / her holdings in the stock of BA.