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Remember An arbitrage opportunity is a trading strategy that never costs you anything today (t = 0) or in the future (t = 1), in any contingency (or in any states of economy: up or down), but has a strictly positive probability of having a strictly positive cash ow at t = 1. The law of one price says that assets promising the same future cash ows have the same price today.
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Denition (Arbitrage)
An arbitrage opportunity is dened as: 1. You do not need any money upfront: this is a zero-cost portfolio. The initial value of the portfolio is zero, that is the ability to make zero net investment (i.e. some assets are held in positive amounts, some in negative amounts and, perhaps, some in zero amounts), 2. Have no probability of loss (The portfolio value at time 1 is nonnegative for all states), 3. Have a positive probability of gain (The portfolio value at time 1 is strictly positive for some states).
Remark
If an arbitrage portfolio exists, there will exist innitely many: for any arbitrage portfolio, scale all the asset holdings up or down by an arbitrary positive proportion; the result is also an arbitrage portfolio. make unbounded prots!
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Arbitrage Portfolio
Denition (Arbitrage)
An arbitrage portfolio is a portfolio which satises: V0 = 0 (i ) P(V1 0) = 1 (ii ) P(V1 > 0) > 0 costs nothing never lose money sometimes win money V0 = 0 Suppose we are able to set-up the following portfolios, which one (if any) are arbitrage portfolio? * V1 (up ) = 1 HH HH j V1 (down) = 0
The preceding conditions are also equivalent to: V0 = 0 (i ) P(V1 0) = 1 (ii ) E[V1 ] > 0 costs nothing never lose money strictly positive payo is expected.
* V1 (up ) = 1 HH HH j V1 (down) = 1
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Arbitrage Portfolio
another example, suppose we can construct the following portfolio, is this an arbitrage portfolio?, is there an arbitrage opportunity in the market? * V1 (up ) = 1 HH H j V1 (down) = 2 H
Arbitrage Portfolio
If * V1 (up ) = 1 V0 = 1 H suppose r = 0, B0 = 1 HH j V1 (down) = 2 H * B1 (up ) = 1 H HH j B1 (down) = 1 H
V0 = 1
arbitrage opportunity
Answer: It depends on the interest rate r ! You can not tell whether a portfolio is an arbitrage portfolio by looking only on the payos (here 1 in upstate and 2 in downstate.)
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Arbitrage Portfolio
If * V1 (up ) = 1 V0 = 1 with r = 1/2, B0 = 1 H HH j H V1 (down) = 2 * B1 (up ) = 1.5 H HH j B1 (d ) = 1.5 H
Arbitrage Portfolio
Conclusion: Interest rate is extremely important, with dierent interest rates we have the same portfolio either leading to arbitrage or not. Long the portfolio and short the bond * 0.5 no arbitrage opportunity H j +0.5 H Question: Under which condition(s) is our simple one-period Binomial model arbitrage free?
0 H H
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= 0, .
Exercise
In fact, if, for instance, one had S0 (1 + r ) Sd , then one could make unbounded riskless prots by initially borrowing an arbitrary amount of money and buying an arbitrary number of shares in the stock at price S0 at time t = 0, followed by selling the stock at time t = 1 at a higher return level than r . In other words, V = (S0 )B + S Write down the details... with > 0
Thus, V satises, V0 = 0, V1 0 and P(V1 > 0) P(S1 = Sd ) > 0. i.e. we have an arbitrage opportunity. Similarly, it can be shown (HMW) that S0 (1 + r ) Sd would also contradict the arbitrage-free assumption.
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This inequality says that if the price of the underlying goes up, it must do so at a rate better than the risk-free rate, If it goes down, it must do so at a rate lower than the risk-free rate.
Contingent Claim
Denition
is equivalent to P, written as P P, means that On = {up , down}, P P(up ) = p (0, 1) and P(down) = 1 p .
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Before solving this problem, it is a priori not clear that the fair price is necessarily unique!.
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Sellers Objective
If Cu = C (up ) and Cd = C (down), then V1 ( ) C ( )
Sellers Objective
For all (a, b ) R 2 : V1 V0 = aS0 + b b + S0 max Cu b (1 + r ) Cd b (1 + r ) , Su Sd Cd b (1 + r ) Cu b (1 + r ) , b + S0 = max b + S0 Su Sd Su S0 (1 + r ) Cu S0 Sd S0 (1 + r ) Cd S0 = max b+ , b+ Su Su Sd Sd Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd
(a,b )
aSu + b (1 + r ) Cu and aSd + b (1 + r ) Cd Cu b (1 + r ) C d b (1 + r ) a and a Su Sd Cu b (1 + r ) Cd b (1 + r ) a max , Su Sd Hence, we will show if V0 = aS0 + b Proof next slides... V1 ( ) C ( ) we have
Su S0 (1 + r ) Cd S0 (1 + r ) Sd Cu + 1+r Su Sd 1+r Su Sd
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Geometrical Proof
Remark
The upper hedging price is the value of the least costly (self-nancing portfolio) strategy composed of market instruments whose pay-o is at least as large as the contingent claim pay-o. positive slop
Su S0 (1+r ) b Su
Sd S0 (1+r ) b Sd
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Buyers Objective
1. Let us determine the Buyers price. Let us consider a buyer who wants to buy a contingent claim with payo C ( ) 0 at maturity t = 1. Suppose the buyer choose to pay the price x 0 for C at time 0. 2. The buyer does not want to run any risk of losing money. The buyer starts with the debt x and tries to nd a portfolio so that the payment C which (s)he receives at time t = 1 makes it possible to cover the debt from time t = 0 by purchasing the c.c. x V1 ( ) + C ( ) 0 3. the largest amount the buyer is willing to pay at time t = 0 is given by hlow := sup{x 0 hlow := sup{x 0 | | (a, b ) R 2 s.t V0 = a S0 + b = x ,
x V1 ( ) + C ( ) 0 }
Buyers Objective
V1 ( ) C ( )
(, ) R 2 s.t V0 = S0 + = x , V1 ( ) C ( ) }
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Buyers Objective
For all (a, b ) R 2 : V1 V0 = aS0 + b b + S0 min Cu b (1 + r ) Cd b (1 + r ) , Su Sd Cu b (1 + r ) Cd b (1 + r ) = min b + S0 , b + S0 Su Sd Su S0 (1 + r ) Cu S0 Sd S0 (1 + r ) Cd S0 = min b+ , b+ Su Su Sd Sd Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd
(a,b )
Geometrical Proof
C
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By considering the following portfolio (same as the seller) The Buyer and Seller should agree for the fair price: hup = hlow Cu Cd Cd Su Cu Sd a= = and b = Su Sd (Su Sd )(1 + r ) we can show that actually hlow = Su S0 (1 + r ) Cd S0 (1 + r ) Sd Cu + 1+r Su Sd 1+r Su Sd Bid price hup = hlow = Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd
= The above analysis shows that the buyer and seller of options have opposing interests that balance at one price only.
Conclusion?
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In actual nancial markets, Arrow-Debreu securities do not trade directly, even if they can be constructed indirectly using a portfolio of securities.
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Question: What is a fair price for theses assets? Idea: Make a portfolio of Arrow-Debreu AD securities which generate the payos of the existing claims: We call it Replication.
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Comments:
The big breakthrough came when two economists (Fischer Black and Myron Scholes in 1973) recognized that arbitrage was the secret to unlocking the pricing formula. Their big insight was that the payo structure of an option can be replicated by a portfolio of market traded assets. Since the cash payos to the portfolio and the option are identical, it must be the case that the price of the option equals the value of the portfolio; otherwise, an arbitrage opportunity would exist. = Law of One Price = Price via Replication
No Arbitrage
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