Scribd
Upload
37 views

Lecture 2: 27 September 2012: 1 Forward Contracts and Other Derivatives

The document discusses the concept of arbitrage and the "no-arbitrage" principle in financial markets. It provides three examples: 1) An opportunity to exchange currencies between two markets at different exchange rates to make a risk-free profit. This arbitrage would disappear as the rates equalized. 2) A market with two securities, A and B, that can be combined to create a portfolio that replicates the payouts of B at no initial cost and no risk of future loss, representing an arbitrage opportunity. 3) A similar situation but where the replicating portfolio only provides a range of possible prices for B, between which no arbitrage is possible, rather than a single price

Uploaded by

Brandon Simmons
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
37 views

Lecture 2: 27 September 2012: 1 Forward Contracts and Other Derivatives

The document discusses the concept of arbitrage and the "no-arbitrage" principle in financial markets. It provides three examples: 1) An opportunity to exchange currencies between two markets at different exchange rates to make a risk-free profit. This arbitrage would disappear as the rates equalized. 2) A market with two securities, A and B, that can be combined to create a portfolio that replicates the payouts of B at no initial cost and no risk of future loss, representing an arbitrage opportunity. 3) A similar situation but where the replicating portfolio only provides a range of possible prices for B, between which no arbitrage is possible, rather than a single price

Uploaded by

Brandon Simmons
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

MATH2515: Financial Mathematics 2

Jitse Niesen

Lecture 2: 27 September 2012


1 Forward contracts and other derivatives

A derivative is a nancial instrument whose value depends on the value of some other asset (the underlying asset ). A simple derivative is a forward contract, which is an agreement to buy a specic asset (e.g., copper) for a specied price at a specic time in the future. The main goal of this chapter is the valuation of forward contracts and other derivatives. The no-arbitrage principle is the tool which allows us to achieve this.

1.1

The no-arbitrage principle

The idea behind the no-arbitrage principle can be summarized in a few words: there is no such thing as a free lunch. In other words, the nancial markets will not allow you to get a risk-free prot. First example of arbitrage A simple example of arbitrage is when a foreign currency is traded on two markets with dierent exchange rates. Suppose that you can exchange euros to pounds in London at a rate of e1.15 per pound, and in Paris at e1.16 per pound. Then it would be possible to get a guaranteed prot by exchanging one pound for e1.16 in .16 1.01 pounds in London, thus getting one penny Paris and then exchanging e1.16 for 1 1.15 of prot. That does not sound very impressive, but by starting with a million pounds, you could get a prot of 8695.65 without any risk. The consequence of this arbitrage opportunity is an increased supply of euros in London which pushes the exchange rate up there. In Paris, the echange rate will drop, until the rates in London and Paris are equal. In well-developed liquid markets, any arbitrage opportunity will disappear quickly. The assumption of no arbitrage is that all arbitrage opportunities have disappeared. Denition Arbitrage opportunities may be more complicated and involve trades at different times. In that case, we need to take into account that future prices are uncertain. An arbitrage opportunity is a deal that either gives an initial prot with no risk of future loss or that has zero initial cost, no risk of future loss and a non-zero probability of a future prot. Second example of arbitrage Consider a market with two securities, A and B. It is A B possible to buy A now (at t = 0) for P0 = 6 pounds. The prize of B is P0 = 11. Both securities have a term of one year and make a single pay-out at the end of the year (at t = 1), but the pay-out is random. There are two possibilities. Either the market goes up, A B (u) = 7 and security B pays P1 (u) = 14. Or the market in which case security A pays P1 A B goes down, in which case security A pays P1 (d) = 5 and security B pays P1 (d) = 10.

MATH2515: Financial Mathematics 2

Jitse Niesen

This market has an arbitrage opportunity. If you buy one unit of security B for 11 and sell two units of security A for 6 each you make a prot of 1 at t = 0. Furthermore, you will not make a future loss (at t = 1), whatever happens. If the market goes up, security B pays out 14, which covers the pay-out you have to make on the two units of security A (2 times 7). If the market goes down, the pay-out of security B also exactly covers your obligations. In this example, two units of A has the same pay-out as one unit of B. We say that these portfolios replicate each other. The no-arbitrage principle says that replicating portifolios should have the same price. This is sometimes called the law of one price. The arbitrage opportunity disappears when security B costs twice as much as security A. Third example of arbitrage This example illustrates the phrase non-zero probability in the denition of arbitrage. The situation is similar to the second example but with dierent numbers: Security A B P0 (price at time 0) 6 6 P1 (u) (pay-out if market goes up) 7 7 P1 (d) (pay-out if market goes down) 5 4

In this situation, an arbitrageur can buy A and sell B. This does not cost anything at t = 0. At t = 1, the arbitrageur either makes a prot of 1 (if the market goes down) or breaks even (if the market goes up). Thus, there is zero initial cost, no risk of a future loss and a non-zero probability of a prot (assuming the probability that the market goes down is not zero); this is an arbitrage opportunity. A B . = 2P0 In the second example, we found that the no-arbitrage principle implies that P0 The principle is not as strong in the situation here. It only gives a range for the price of B, given the price of A. The underlying reason is that we cannot construct replicating portfolios in this situation if A and B are the only securities on the market. A B Assume that P0 = 6 (as before) but that P0 is not xed. Then a deal with zero B initial cost is to buy P0 units of A and to sell 6 units of B. This leads to a pay-out of A B B B A B B B (d)6P1 (d) = 5P0 24 P1 (u)6P1 (u) = 7P0 42 if the market goes up and P0 P1 P0 if the market goes down. The no-arbitrage principle means that one of them must be B B negative (or both zero), so either 7P0 42 < 0 or 5P0 24 < 0. It follows that either B B P0 < 42/7 = 6 or P0 < 24/5 = 4.8, so the price of B has to be below 6. B Another deal with zero initial cost is to sell P0 units of A and to buy 6 units of B. A similar reasoning yields that the no-arbitrage principle implies the price of B has to be above 4.80. Thus, the price of B has to be between 4.80 and 6.00.

You might also like