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No Arbitrage = Law of One price

Introduction to Mathematical Finance: Part I: Discrete-Time Models


AIMS and Stellenbosch University April-May 2012

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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What Does Arbitrage Free Mean?


Denition (Mathematical Denition of Arbitrage)
An arbitrage portfolio is a portfolio which satises: V0 = 0 (i ) P(V1 0) = 1 (ii ) P(V1 > 0) > 0 (i ) (ii ) V0 ( ) = 0 V1 ( ) 0 V1 ( ) > 0 costs nothing never lose money sometimes win money costs nothing no chance of losing money some chance of making money

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.

V0 = 0 E[V1 ] = pV1 (up ) + (1 p )V1 (down)

* 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

Long the portfolio and short the bond * 0 0 HH H j 1 H

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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Conditions for Arbitrage-free

Necessary and Sucient Conditions for Arbitrage-free in Binomial Market


Theorem (Necessary and Sucient Conditions for Arbitrage-free)
In the one-period binomial market model consisted of a risky asset S and a risk-free asset B, we have The market is arbitrage-free if and only if Sd < S0 (1 + r ) < Su . Proof. = Suppose that Sd < S0 (1 + r ) < Su is false, e.g. S0 (1 + r ) Su . Consider the following portfolio: V = S + S0 B. B0

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Necessary and Sucient Conditions for Arbitrage-free


The values at time t = 0 and at t = 1 are: V0 = S0 + V1 = S1 + Therefore,
S0 V1 (up ) = S1 (up ) + B B1 = S0 (1 + r ) Su 0 , 0 S0 B1 = S0 (1 + r ) Sd > 0 . V1 (down) = S1 (down) + B 0 S0 B0 B0 S0 B0 B1

Hint for HMW

= 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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Conditions for Arbitrage-free


Remark (Interpretation of the Conditions for Arbitrage-free)
Sd < S0 (1 + r ) < Su Sd B1 Su < =1+r < S0 B0 S0 Sd S0 B1 B0 Su S0 < =r < S0 B0 S0 Here p := P(up ) ]0, 1[ and Su > Sd . We have that the One-Period Binomial Model (OPBM) does not admit arbitrage if and only if [S1 ] | P P} S0 (1 + r ) ]Sd , Su [= {p S u + (1 p )Sd | p ]0, 1[} = {E i.e. S0 (1 + r ) is a convex combination of Sd and Su .
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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 .

Valuation Problem: Fair Price

Denition (Contingent Claim)


A Contingent Claim is a contract which will pay something in the event of something, in other words, a contract that pay a particular amount contingent that something happen. For example, a function of the risky asset S . In the sequel we will work on the assumption that arbitrage does not occur and we will rely on this hypothesis for the pricing of contingent claims. i.e. we have Sd < (1 + r )S0 < Su

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Fair Price(s) Problem

Sellers Objective=Writers Objective


1. From the claim C writers perspective. At time t = 1 he has a liability/debt of (C1 (up ), C1 (down)) 0, depending on which of the two states occurs. 2. At time t = 0, the writer is willing to accept any amount x 0 which enables him to make good on his commitment at time t = 1: i.e. to have enough capital at time t = 1 to cover his obligation (to hedge the contingent claim C at time t = 1) 3. The sellers objective is, starting with the amount x 0 that S/he receives at time t = 0, to nd a portfolio strategy s.t. V0 ( ) = x and V1 ( ) C ( ) 0 for all 4. In order to be competitive and win the deal, the seller will sell C for the amount (the smallest one) hup := inf {x 0 | (a, b ) R 2 s.t V0 = a S0 + b = x , V1 ( ) C ( ) }

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

Conclusion hup Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd


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Geometrical Proof

Sellers Objective: Ask Price


By considering the following portfolio a= Cu Cd Su Sd and b = Cd Su Cu Sd (Su Sd )(1 + r )

we can show that actually hup = Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd Ask price

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

+ and negative slop

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 ( )

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 min , Su Sd

(, ) 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

Conclusion hlow Cu Su S0 (1 + r ) Cd S0 (1 + r ) Sd + 1+r Su Sd 1+r Su Sd


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Buyers Objective: Bid Price

Seller and Buyers Objective: Conclusion

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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Valuation Problem: Fair Price via Arbitrage Argument

State-Prices aka Arrow-Debreu prices or prices of pure securities


Denition (Arrow-Debreu Securities)
Arrow-Debreu Securities: Consider two ctitious assets which pay exactly 1 in one of the two states of the world and zero in the other.

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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State-Prices aka Arrow-Debreu prices or prices of pure securities

State-Prices aka Arrow-Debreu prices or prices of pure securities


Question: What is a fair price for theses assets?

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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Big Breakthrough: Valuation by replication

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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