Arbitrage is the process of increasing income without having to increase the levels of risk involved in making the investment. It is a process of making a riskless gain. An arbitrage opportunity arises when a project is capable of giving returns that are more than or equal to the risk-free rate of return. Arbitrage may be looked into from another perspective, where an investor buys securities from one market and simultaneously sells the same securities to another market so that he profits from the price difference between the two security markets. For example, an investor may buy 1000 shares in stock exchange market A at $ 1000 and then sell the 1000 shares in stock exchange market B for $1200. A similar opportunity may arise in the derivatives markets.

To check the arbitrage opportunity for an option we consider the forward price and the spot price of the particular derivative to determine whether it is “in the money”, “at the money” or “out of the money”. An option is said to be in the money if it leads to a positive cash flow to the holder of the option if exercised immediately. A call option is said to be in the money if the actual price/ sport price of the underlying asset is greater than its strike price. A put option is said to be in the money if its spot price is less than its strike price. An option is said to be out of the money if it leads to a negative cash flow to the holder of the option if exercised immediately. A call option is said to be “out of the money” if its actual price is less than its strike price. A put option is said to be out of the money if the spot price of the underlying asset is greater than its strike price.

An option can also be at the money where it leads to a zero cash flow for the holder of the option if exercised immediately. An option (cash or put) is said to be at the money if the actual price of the underlying asset is equal to the strike price. The arbitrage pricing model can be used to value the underlying asset. This pricing model holds that the expected rate of return of a financial asset can be modeled as a linear function of various macroeconomic factors or theoretical market indices such as industrial production, interest rates, inflation, etc. The asset price should equal the expected end-of-period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. According to this pricing model, an investor will explore the possibility of forming an arbitrage portfolio without increasing risk.