Q. Define Arbitrage Process ?
The basic theory of the MM approach if we ignore the taxes is that the total value of a firm should be constant irrespective of the degree of leverage. In other words the fundamental preposition of the MM approach is that the capital structure decision is irrelevant. MM approach offers behavioural justification for the irrelevance of the capital structure decision and isn't content with merely stating the preposition. The justification slander in the arbitrage process.
Arbitrage process engages buying and selling of those securities whose prices are lower (undervalued securities) as well as selling those securities whose prices are higher (overvalued securities). Buying the undervalued securities will raise their demand and will result in raising their prices and the selling of overvalued securities will raise their supply thereby bringing down their prices. This will carry on till the equilibrium is restored. The arbitrage process guarantees that the securities of two identical firms cannot sell at different prices for long.