Chapter 2 A primer on the arbitrage theorem.pptVIP

CHAPTER 2A Primer on the Arbitrage Theorem Introduction(1) In its simplest form, arbitrage means taking simultaneous position in different assets so that one guarantees a riskless profit higher than the riskless return given by U.S Treasury bills. If such profits exits, we say that there is an arbitrage opportunity. Arbitrage opportunities can arise in two different fashions. Introduction(2) In the first way, one can make a series of investment with no current net commitment, yet expect to make a positive profit. For example, one can short-sell a stock and use the proceeds to buy call options written on the same security…… In the second kind, a portfolio can ensure a negative net commitment today, while yielding nonnegative profits in the future. Introduction(3) We use APT to obtain a practice definition of a “fair price” for a financial. In practice, arbitrage opportunities may exist. This, however, would not reduce our interest in “ arbitrage-free” price. We can imagine at least four possible utilizations of arbitrage-free price. Introduction(4) 1.One case may be when a derivatives house decides to engineer a new financial product whose actual price process can not be observed. 2.In risk management, future uncertainties are a series of hypothetical evens that has not been observed. 3.In the process of marking to market. When a treasurer want to know the current value of a nonliquid asset. Introduction(5) 4. Comparing arbitrage-free prices with actual prices, traders can find excess profit opportunities. Notation(1) Asset Prices where the index t will represent time. St may be vector of asset prices at time of t. Notation(2) States of the World where each represents a distinct outcome that may occur. These states are mutually exclusive, and at least one of them is guaranteed to occur. Notation(3) Returns and payoffs where dij denote the number of units of account paid by one unit of security i in state j. dij includes two comp