ARBITRAGE AND MARKET DYNAMICS: A

PROBABILITY-BASED APPROACH

LEILA OUKACHA

Abstract. This paper explores the application of probability theory to arbi-

trage. While no advanced probability knowledge is assumed, familiarity with
basic probability is required. After introducing probability spaces, random
variables, and distributions to define martingales, we apply these concepts to
arbitrage-free markets. We cover stock arbitrage in a single-period market
and conclude with the fundamental theorem of arbitrage pricing. Ultimately,
we extend our analysis to multi-period markets by deriving the martingale
representation theorem.

Contents
1. Preliminaries 2
1.1. Probability Spaces 2
1.2. Random Variables 2
1.3. Distributions 3
2. Martingales 5
2.1. Conditional Expectation 5
2.2. Martingale 6
3. Application to arbitrage and no-arbitrage pricing in finance 9
3.1. Arbitrage 9
3.2. Arbitrage-free single-period market 10
3.3. The Martingale Representation Theorem and Hedging in a multi-
period market 13
Acknowledgments 15
4. Bibliography 15
References 15

Date: Ausgut 26th, 2024.

1
2 LEILA OUKACHA

1. Preliminaries
1.1. Probability Spaces.
Definition 1.1.1. A probability space is a triple (Ω, F, P) where Ω is a set of
“outcomes”, F is a set of “events”, and P : F → [0, 1] is a function that assigns
probability to events.
Definition 1.1.2. (Ω, F) is a measurable space. A measure is a nonnega-
tive countably additive set function such that µ : F→ R satisfies the following
properties:
(i) µ(A) ≥ µ(∅) = 0 for all A ∈ F. S P
(ii) If Ai ∈ F is a countable sequence of disjoint sets, then µ ( i Ai ) = i µ(Ai ).
(iii) If µ(Ω) = 1, then µ is defined as a probability measure usually denoted
by P.
Example 1.1.3. Discrete probability spaces. Let Ω be a finite or infinite
countable set and F be the set of all subsets of Ω. Also, assume that A ⊂ F.
P P
Then, P (A) = ω∈A p(ω), where p(ω) ≥ 0 and ω∈Ω p(ω) = 1.
Proposition 1.1.4. A sigma-algebra F on a set Ω is a collection of subsets
of Ω satisfying the following properties:
(i) Ω ∈ F.
(ii) If A ∈ F, then Ω \ A ∈ F. S
∞
(iii) If A1 , A2 , A3 , . . . ∈ F, then i=1 Ai ∈ F.
Definition 1.1.5. The Borel sigma-algebra B(R) on R is the smallest sigma-
algebra containing all open subsets of R.
1.2. Random Variables.
Definition 1.2.1. A function X : Ω → S is said to be a measurable map from
(Ω, F) to (S, S) if X−1 (B) ≡ {ω : X(ω) ∈ B} ∈ F, ∀B ∈ S.
Definition 1.2.2. If (S, S) = (R, B(R)), then X is called a random variable.
Example 1.2.3. The indicator function of a set A ∈ F is a random variable:
(
1 if ω ∈ A
1A (ω) =
0 if ω ∈ /A
Theorem 1.2.4. If {ω : X(ω) ∈ A} ∈ F for all A ∈ A and A generates S such
that S is the smallest σ-field that contains A, then X is measurable.
Proof. Letting {X ∈ B} be equivalent to {ω : X(ω) ∈ B}, we have

∈ Bi } and {X ∈ B c } = {X ∈ B}c .
S S
{X ∈ i Bi } = i {X

So the class of sets B = {B : {X ∈ B} ∈ F} is a σ-field.

Since B ⊃ A and A generates S, B ⊃ S. □

 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 3

Theorem 1.2.5. If X : (Ω, F) → (S, S) and f : (S, S) → (T, T ) are measurable

maps, then f (X) is a measurable map from (Ω, F) to (T, T ).
Proof. Let B ∈ T . Then f −1 (B) ∈ S.

Thus, {ω : f (X(ω)) ∈ B} = {ω : X(ω) ∈ f −1 (B)} ∈ F. □

Theorem 1.2.6. If X1 , . . . , Xn are random variables and f : (Rn , Rn ) → (R, R)
is measurable, then f (X1 , . . . , Xn ) is a random variable.
Proof. First, observe that if A1 , . . . , An are Borel sets, then
\
{(X1 , . . . , Xn ) ∈ A1 × · · · × An } = {Xi ∈ Ai } ∈ F.
i
Since sets of the form A1 × · · · × An generate Rn , (X1 , . . . , Xn ) is a random vector.

It follows by Theorem 1.2.4 that X1 , . . . , Xn is measurable.

So, by Theorem 1.2.5, f (X1 , . . . , Xn ) is a measurable map from (Rn , Rn ) → (R, R),
which proves that f (X1 , . . . , Xn ) is a random variable. □
Theorem 1.2.7. If X1 , . . . , Xn are random variables, then so are inf n Xn , supn Xn ,
lim supn Xn , and lim inf n Xn .
S
Proof.SFirst, observe that {inf Xn < a} = n {Xn < a} ∈ F. Similarly, {sup Xn >
a} = n {Xn > a} ∈ F.

Now, remark that

lim inf Xn = sup inf Xm
n→∞ n m≥n
Note that Yn = inf m≥n Xm is a random variable for each n, so supn Yn is as well.

Similarly,
lim sup Xn = inf sup Xm
n→∞ n m≥n

Zn = supm≥n Xm is a random variable for each n, so inf n Zn is as well, which

completes the proof. □
1.3. Distributions.
Definition 1.3.1. A distribution function of a random variable is a function
F : R → [0, 1] such that F (x) = P (X ≤ x) where X is a random variable.
Proposition 1.3.2. Any distribution function F has the following properties:
(i) F is nondecreasing: F (x1 ) ≤ F (x2 ) whenever x1 ≤ x2 .
(ii) lim F (x) = 1, lim F (x) = 0.
x→∞ x→−∞
(iii) F is right continuous: lim F (y) = F (x).
y↓x
(iv) If F (x−) = lim F (y), then F (x−) = P (X < x).
y↑x
(v) P (X = x) = F (x) − F (x−).
4 LEILA OUKACHA

Proof.

(i) Given x ≤ y, we have {X ≤ x} ⊂ {X ≤ y}. By the monotonicity of

probability measures,
P (X ≤ x) ≤ P (X ≤ y).
Hence, F (x) ≤ F (y). Therefore, F (x) is nondecreasing.
(ii) • limx→∞ F (x) = 1:
As x → ∞, {X ≤ x} → Ω, so F (x) → 1.
• limx→−∞ F (x) = 0:
As x → −∞, {X ≤ x} → ∅, so F (x) → 0.
(iii) For any sequence yn ↓ x, {X ≤ yn } ↓ {X ≤ x}. By the right-continuity of
measures,
lim F (yn ) = F (x).
n→∞
Hence, F is right continuous.
(iv) If F (x−) = limy↑x F (y), then F (x−) = P (X < x):
If F (x−) = lim F (y), then
y↑x
{X ≤ yn } ↑ {X < x} as yn ↑ x.
Thus, F (x−) = P (X < x).
(v)
P (X = x) = P (X ≤ x) − P (X < x).
Using properties (iii) and (iv), we get P (X = x) = F (x) − F (x−). □
Theorem 1.3.3. If a function F : R → [0, 1] satisfies (i), (ii), and (iii) of Propo-
sition 1.3.2, then it is the distribution function of some random variable.
Proof. Let Ω = (0, 1), F = the Borel sets, and P = Lebesgue measure.

Fix ω ∈ (0, 1) such that X(ω) = sup{y : F (y) < ω}.

We must show that

(1) {ω : X(ω) ≤ x} = {ω : ω ≤ F (x)}

Observe that
• If ω ≤ F (x), then X(ω) ≤ x, since x ∈/ {y : F (y) < ω}.
• On the other hand, if ω > F (x), then, since F is right continuous, there
exists ϵ > 0 such that F (x + ϵ) < ω and X(ω) ≥ x + ϵ > x.

Therefore, P ({ω : ω ≤ F (x)}) = F (x) which proves (1). □

(
λe−λx for x ≥ 0,
Example 1.3.4. Exponential distribution with rate λ such that f (x) =
0 otherwise.
(
0 if x < 0,
Distribution function: F (x) =
1 − e−λx if x ≥ 0.
 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 5

2. Martingales
2.1. Conditional Expectation.
Definition 2.1.1. Let G be a sub-σ-algebra of F, and X ∈ L1 be a random
variable. Then the random variable ξ, denoted by E[X | G], is the conditional
expectation of X with respect to G if
(i) ξ ∈ L1 ,
(ii) ξ is G-measurable,
(iii) E[ξ · 1A ] = E[X · 1A ], for all A ∈ G.
Proposition 2.1.2. Properties of Conditional Expectation
Let X ∈ L2 (Ω, F, P ) and let G be a σ-algebra contained in F. Then Conditional
Expectation satisfies the following properties:

(1) Linearity: E(aX1 + bX2 |G) = aE(X1 |G) + bE(X2 |G).

(2) Orthogonality: X − E(X|G) ⊥ L2 (Ω, G, P ).
(3) Best Prediction: E(X|G) minimizes E[(X−Y )2 ] among all Y ∈ L2 (Ω, G, P ).
(4) Tower Property: If H is a σ-algebra contained in G, so that H ⊆ G ⊆ F,
then
E(X|H) = E(E(X|G)|H).
(5) Covariance Matching: E(X|G) is the unique random variable Z ∈ L2 (Ω, G, P )
such that for every Y ∈ L2 (Ω, G, P ),
E(XY ) = E(ZY ).
(6) Normalization: E(1|G) = 1 almost surely.
(7) Positivity: For any nonnegative, bounded random variable X,
E(X|G) ≥ 0 almost surely.
(8) Monotonicity: If X, Y are bounded random variables such that X ≤ Y
almost surely, then
E(X|G) ≤ E(Y |G) almost surely.
(9) Jensen’s Inequalities: If ϕ : R → R is convex and E|X| < ∞, then
E(ϕ(X)) ≥ ϕ(E(X)) and E(ϕ(X)|Y ) ≥ ϕ(E(X|Y )).
Proof. Omitted. □
Theorem 2.1.3. Monotone Covergence Theorem Let Xn be a sequence of
random variables such that Xn ≥ 0 for all n, and Xn → X as n → ∞.

Then, E(Xn ) → E(X) as n → ∞.

Proof. Omitted. □
6 LEILA OUKACHA

Theorem 2.1.4. Conditional Monotone Convergence Theorem

Let Xn be a nondecreasing sequence of nonnegative random variables on a prob-

ability space (Ω, F, P ), and let X = limn→∞ Xn . Then for any σ-algebra G ⊂ F,
E(Xn | G) ↑ E(X | G).
Proof. By Linearity (1) and Positivity (7) in Proposition 2.1.2,
E(Xn | G) ≤ E(Xn+1 | G) ≤ E(X | G) ∀n ∈ N.
Then, the limit V := limn→∞ E(Xn | G) exists almost surely, and V ≤ E(X | G).
Moreover, since each conditional expectation is G-measurable, so is V .

To prove V = E(X | G) almost surely, define the set

B = {V < E(X | G)}.

We need to show that P(B) = 0.

Since B ∈ G, we have by Definition 2.1.1 and the Tower Property (4) in Proposi-
tion 2.1.2,
E(X · 1B ) = E(E(X | G) · 1B ) and E(Xn · 1B ) = E(E(Xn | G) · 1B ).
But, by Theorem 2.1.3,
E(X · 1B ) = lim E(Xn · 1B ) and E(V · 1B ) = lim E(E(Xn | G) · 1B ),
n→∞ n→∞

so E(X · 1B ) = E(V · 1B ) which is a contradiction since V < X on B.

Thus, P (B) = 0. □
2.2. Martingale.
Definition 2.2.1. Let {Fn } denote the information in A1 , A2 , . . . , A∞ such that
information refers to the collection of data or events available up to a given time
t. Then a filtration of a set Ω (finite or infinite) is defined to be a collection Ft ,
indexed by a time parameter t (discrete or continuous), such that
(1) Each Ft is a σ-algebra of subsets (events) of Ω;
(2) If s < t, then Fs ⊆ Ft .
Example 2.2.2. Suppose X1 , X2 , . . . are independent, identically distributed ran-
dom variables with mean µ.

Let Sn denote the partial sum Sn = X1 + · · · + Xn and Fn denote the infor-

mation in X1 , . . . , Xn .

Suppose m < n. Then by linearity in Proposition 2.1.2,

(1) E(Sn | Fm ) = E(X1 + · · · + Xm | Fm ) + E(Xm+1 + · · · + Xn | Fm ).
Since X1 + · · · + Xm is measurable with respect to Fm , by the constants property
stating that for any scalar a, E(a | G) = a, we have:
(2) E(X1 + · · · + Xm | Fm ) = X1 + · · · + Xm = Sm .
 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 7

Since Xm+1 + · · · + Xn is independent of Fm , we have:

(3) E(Xm+1 + · · · + Xn | Fm ) = E(Xm+1 + · · · + Xn ) = (n − m)µ.
Therefore, by (2) and (3) in (1),
E(Sn | Fm ) = Sm + (n − m)µ.
Definition 2.2.3. A sequence of random variables M0 , M1 , M2 , . . . with E(|Mi |) <
∞ is a martingale with respect to {Fn } if each Mn is measurable with respect to
Fn such that for each m < n,

(1) E(Mn | Fm ) = Mm .
Equivalently,
(2) E(Mn − Mm | Fm ) = 0.
Example 2.2.4. “Martingale betting strategy”

Suppose X0 , X1 , . . . are independent random variables with

P{Xi = 1} = P{Xi = −1} = 21 .

Then think of the random variables Xi as the results of a game where one flips
a coin where:

(i) If it comes up heads, then one wins $1.

(ii) If it comes up tails, then one loses $1.

To beat the game, we will keep doubling our bet until we eventually win. At
this point, we stop.

Let Wn denote the winnings (or losses) up through n flips of the coin using this
strategy and let W0 = 0. Whenever we win, we stop playing, so our winnings stop
changing such that
P{Wn+1 = 1 | Wn = 1} = 1.

Now, suppose that the first n flips of the coin have turned up tails. After each flip,
we have doubled our bet, so we have lost 1 + 2 + 4 + . . . + 2n−1 = 2n − 1 dollars
and Wn = −(2n − 1). At this time, we double our bet again and wager 2n on the
next flip. This gives
1
P Wn+1 = − 2n+1 − 1 | Wn = − (2n − 1) = .


2
Therefore,
E(Wn+1 | Fn ) = Wn .
Hence, by Definition 2.2.3, Wn is a martingale with respect to Fn .
8 LEILA OUKACHA

Definition 2.2.5. Let (Ω, F, P ) be a probability space and (Ft )0≤t≤T or (Ft )0≤t<∞
be a filtration by sub-σ-algebras of F. An adapted sequence Xt of integrable random
variables is defined to be a
• Martingale if E(Xt+1 | Ft ) = Xt , ∀t.
• Submartingale if E(Xt+1 | Ft ) ≥ Xt , ∀t.
• Supermartingale if E(Xt+1 | Ft ) ≤ Xt , ∀t.
Example 2.2.6. Let {Xn }n≥0 be a martingale relative to the filtration {Fn }n≥0 ,
and ϕ : R → R be a convex function such that E[ϕ(Xn )] < ∞ for each n ≥ 0. Then
the sequence {Zn }n≥0 defined by
Zn = ϕ(Xn )
is a submartingale relative to the filtration {Fn }n≥0 by Definition 2.2.5.

This is a consequence of Jensen’s inequality and the martingale property of {Xn }n≥0 :
E[Zn+1 | Fn ] = E[ϕ(Xn+1 ) | Fn ]
≥ ϕ(E[Xn+1 | Fn ])
= ϕ(Xn ) = Zn .

Theorem 2.2.7. Martingale Convergence Theorem

Suppose M0 , M1 , . . . is a martingale with respect to {Fn } such that there exists

a C < ∞ with E(|Mn |) < C for all n. Then there exists a random variable M∞
such that
Mn → M∞

Proof. We will show is that for every 0 < a < b < ∞, the probability that the mar-
tingale fluctuates infinitely often (ie: the probability that the martingale diverges)
between a and b is 0.

Fix a < b. We will consider the following betting strategy:

1) Think of Mn as giving the cumulative results of some fair game and Mn+1 − Mn
as being the result of the game at time n + 1.

2) Whenever Mn < a, bet 1 on the martingale. Continue this procedure until

Mn > b.

3) Stop betting until Mn < a again and return to betting 1. Continue this process,
changing the bet to 0 when Mn > b and changing back to 1 when Mn < a.

After n steps, the winnings in this strategy are given by

n
X
Wn = Bj (Mj − Mj−1 ),
j=1

where Bj is the bet which equals 1 if Mn < a or 0 if Mn > b.

 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 9

Note that
Wn ≥ (b − a)Un − |Mn − a|,
where Un denotes the number of times that the martingale goes between a and b
(ie: the number of upcrossings) and Mn − a gives an estimate for the amount lost
in the last interval. Since Wn is a martingale, we have
(1) E(W0 ) = E(Wn ) ≥ (b − a)E(Un ) − E(|Mn − a|).
By the triangle inequality,
(2) E(|Mn − a|) ≤ E(|Mn |) + a ≤ C + a.

Thus, by (1) and (2),

E(W0 ) + C + a
E(Un ) ≤ .
b−a
Since this holds for every n, the expected number of upcrossings from a to b in
R is bounded for any a,b in R. Thus, the number of upcrossings is finite almost
surely. □
Example 2.2.8. Let X1 , X2 , . . . be independent random variables with
3 1 1
P{Xi = } = P{Xi = } = .
2 2 2
Let M0 = 1 and for n > 0, let Mn = X1 X2 · · · Xn such that
E[Mn ] = E[X1 ]E[X2 ] · · · E[Xn ] = 1.

If Fn denotes the information contained in X1 , X2 , . . . , Xn , then

E[Mn+1 |Fn ] = E[X1 X2 · · · Xn Xn+1 |Fn ]
= X1 X2 · · · Xn E[Xn+1 |Fn ]
= X1 X2 · · · Xn E[Xn+1 ]
= Mn .

Hence, by Definition 2.2.3, Mn is a martingale with respect to X1 , X2 , . . . Xn .

Since E[|Mn |] = E[Mn ] = 1, the conditions of the martingale convergence theo-

rem hold. Thus,
Mn → M∞ for some random variable M∞ .

3. Application to arbitrage and no-arbitrage pricing in finance

3.1. Arbitrage.
Definition 3.1.1. An asset is a resource owned or controlled by an individual,
organization, or entity that is expected to provide future economic benefits.
Definition 3.1.2. A position refers to the amount of a particular asset, security,
or financial instrument that an individual, company, or entity holds. The term is
commonly used in the context of investments, trading, and portfolio management.
10 LEILA OUKACHA

Definition 3.1.3. Arbitrage is the act of taking simultaneous positions in differ-

ent assets to guarantee a riskless profit higher than the risk-free rate, such as that
from US Treasury bills.
Remark 3.1.4. By identifying and exploiting market inefficiencies, traders search
for price discrepancies in large, liquid markets and execute rapid, high-volume
trades to capitalize on these differences. They buy a security in one market and
sell it in another at a higher price, using the sale proceeds to pay for the purchase
and pocketing the profit.
3.2. Arbitrage-free single-period market.
Remark 3.2.1. In the absence of arbitrage, the market imposes a probability dis-
tribution, called a risk-neutral or equilibrium measure, on the set of possible
market scenarios. This probability measure determines market prices through dis-
counted expectation, which refers to the process of adjusting the expected future
value of a financial asset or cash flow to account for the time value of money. This
leads us to the Fundamental Theorem of Arbitrage Pricing.
Definition 3.2.2. Single Period market

Consider a market in which

(i) The share price of asset Aj at time t = 0 is S0j . Assume that S01 = 1.
(ii) A1 , A2 , . . . , AK are K freely traded assets such that A1 is riskless (ie: S01
is independent of the market scenario).
(iii) The finite set Ω = ω1 , ω2 , . . . , ωN corresponds to N possible market scenar-
ios.
(iv) The share prices S12 , S13 , . . . , S1K of the K − 1 assets at time t = 1 are
functions of the market scenario.
Example 3.2.3. In scenario ωi , there is an N × K matrix with entries S1j (ωi )
corresponding to the price of a share of Aj at time t = 1.

Since A1 is riskless by Definition 3.2.2, the share price S11 of A1 in any scenario ωi
where r is the riskless rate of return is defined as follows:
S11 (ωi ) = er ∀i = 1, 2, . . . , N.
Definition 3.2.4. Portfolios. A portfolio is a vector
θ = (θ1 , θ2 , . . . , θK ) ∈ RK
of K real numbers such that θj is the number of shares of asset Aj that are owned.
If θj < 0, then the portfolio is said to be short |θj | shares of asset Aj .
 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 11

Proposition 3.2.5.

(i) The value of the portfolio θ at time t = 0 is

K
X
V0 (θ) = θj S0j
j=1

(ii) The value of the portfolio θ at time t = 1 in market scenario ωi is

K
X
V1 (θ; ωi ) = θj S1j (ωi )
j=1

Definition 3.2.6. Arbitrage. An arbitrage is a portfolio θ that makes money

from nothing. Formally, an arbitrage is a portfolio θ such that either
V0 (θ) ≤ 0 and V1 (θ; ωj ) > 0, ∀j = 1, 2, . . . , N
or
V0 (θ) < 0 and V1 (θ; ωj ) ≥ 0, ∀j = 1, 2, . . . , N.
Definition 3.2.7. Equilibrium Measure. If, for every asset A, the share price
of A at time t = 0 is the discounted expectation, under π, of the share price at time
t = 1 such that
N
X
(1) S0j = e−r π(ωi )S1j (ωi ) ∀j = 1, 2, . . . , K,
i=1

then a probability distribution πi = π(ωi ) on the set Ω is an equilibrium measure

(or risk-neutral measure).
Lemma 3.2.8. Let F be a closed, bounded, convex subset of Rk and let x ∈ Rk −F .
Then there is a unique nonzero vector v ∈ Rk such that
v·x≤v·y ∀y ∈ F,
Proof. Assume that x = 0 (the origin in Rk ). Let v ∈ F be the element of F closest
to the origin 0. Then such a point exists since F is closed and bounded; it is unique
since F is convex; the vector v cannot be the zero vector since 0 ∈/ F.

Since x = 0, we will show that v · y > 0 for all elements y ∈ F .

The dot product is unchanged by rotations of Rk about the origin, so assume

that the vector v lies on the first coordinate axis such that
v = (a, 0, 0, . . . , 0) for some a > 0.
Thus, to prove that v · y > 0 for all elements y ∈ F , it suffices to show that there
is no y ∈ F whose first coordinate is nonpositive.

Suppose, for the sake of contradiction, that there exists a point y ∈ F with a
nonpositive first coordinate. Then the line segment L has endpoints v and y such
that L ⊂ F . Because this line segment must cross the hyperplane consisting of
points with first coordinate 0, we may suppose that y has the form
y = (0, y2 , y3 , . . . , yk ),
12 LEILA OUKACHA

Let L consist of all points of the form y(ϵ) := ((1 − ϵ)a, ϵy2 , ϵy3 , . . . , ϵyk ), where
0 ≤ ϵ ≤ 1.

Now, the closest point to the origin on L must be v. But, for all sufficiently
small ϵ > 0, the point y(ϵ) is actually closer to the origin than v, which is a con-
tradiction. □
Theorem 3.2.9. Fundamental Theorem of Arbitrage Pricing. There exists
an equilibrium measure if and only if arbitrages do not exist.
Proof.

(i) There exists an equilibrium measure =⇒ arbitrages do not exist.

Suppose that there is an equilibrium measure π. Then for any portfolio

θ, the portfolio values at time t = 0 and t = 1 are related by the discounted
expectation:
N
X
(1) V0 (θ) = π(ωi )e−r V1 (θ; ωi ).
i=1

In the case for an arbitrage portfolio, if V1 (θ; ωi ) > 0 for every market sce-
nario ωi , then (1) implies that V0 (θ) > 0, and so θ cannot be an arbitrage
by Definition 3.2.6. Thus, arbitrages do not exist.

(ii) Arbitrages do not exist =⇒ there exists an equilibrium measure.

We must show that if the market does not admit arbitrages, then it has an
equilibrium measure π, that is, a probability distribution π(ωi ) on the set
Ω of market scenarios ωi such that (1) in Definition 3.2.7 holds.

First, for j = 1, asset 1 is the riskless asset, so its share price at time
t = 0 is S01 = 1 and its share price at time t = 1, under any scenario ωi , is
er . So for any probability distribution π on the set of market scenarios,
N
X N
X
1 = S01 = e−r π(ωi )er = e−r π(ωi )S11 (ωi ).
i=1 i=1

Thus, if j = 1, then equation (1) in Definition 3.2.7 holds.

Second, for 2 ≤ j ≤ K, consider the set E of all vectors y = (y2 , y3 , . . . , yK )

that can be obtained from the discounted share prices by averaging against
some probability distribution π on Ω. Then,
N
X
(2) yj = e−r π(ωi )S1j (ωi ) ∀j = 2, 3, . . . , K.
i=1

The set E is a bounded, closed, convex polytope in RK−1 . Now, we must

show that, in the absence of arbitrages, we have S = (S02 , S03 , . . . , S0K ) where
S ⊂ E.
 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 13

Equivalently, we will show that if S ∈/ E, then there would be an arbi-

trage. Using Lemma 3.2.8, we will show that if the time-zero price vector
S is not an element of E, then there is an arbitrage. Suppose, then, that
S∈ / E.

Since E is a closed, bounded, convex set, the Separating Hyperplane The-

orem implies that there is a nonzero vector
θ∗ = (θ2 , θ3 , . . . , θK ).
Then by Lemma 3.2.8,
S · θ∗ < y · θ∗ , ∀y ∈ E.
Because E includes points of the form (2) where the probability distribution
π puts all its mass on a single scenario ωi , it follows that, for each scenario
ωi ,
XK K
X
e−r θj S1j (ωi ) > θj S0j .
j=2 j=2

We can choose a real number −θ1 that lies between these two values. Then
adding θ1 to both sides of the previous inequality shows that for every
market scenario ωi ,
K
X K
X
e−r θj S1j (ωi ) > 0 > θj S0j .
j=1 j=1

This implies that the portfolio θ = (θ1 , θ2 , . . . , θK ) is an arbitrage by Defi-

nition 3.2.6. Thus, if θ is not an arbitrage, then there exists an equilibrium
measure.
□

3.3. The Martingale Representation Theorem and Hedging in a multi-

period market.
Remark 3.3.1. In a multi-period market, information about the market sce-
nario is revealed in stages. Some events may be completely determined by the end
of the first trading period, others by the end of the second, and others not until the
termination of all trading, which suggests the following classification of events.
Definition 3.3.2. Filtration in a multi-period market

For each t ≤ T ,
Ft = {all events determined in the first t trading periods}.
The finite sequence (Ft )0≤t≤T is a filtration (ie: Definition 2.2.1) of the space Ω of
market scenarios.
Remark 3.3.3. The share prices of assets in a multiperiod market depend on
market scenarios, but evolve in such a way that their values at any time t, being
observable at time t, do not depend on the unobservable post-t futures of the
scenarios.
14 LEILA OUKACHA

Definition 3.3.4. Adapted Processes. The price process St of a traded asset is

adapted to the natural filtration (Ft )0≤t≤T by Definition 3.3.2. Formally, a sequence
Xt of random variables is adapted to a filtration (Ft )0≤t≤T if, for each t, the random
variable Xt is Ft -measurable.

Example 3.3.5. The Two-Period Binary Market.

There are four market scenarios:

Ω = {++, +−, −+, −−}.

(i) For each scenario, the first (respectively, second) entry indicates whether the
share price of the asset stock increased or decreased in the first (respectively, sec-
ond) trading period.

(ii) There are 42 = 16 events (subsets of Ω) in all.

(iii) The only events that are determined before the first trading period are the
trivial events ∅ and Ω.

(iv) There are two other events determined by time t = 1:

F + = {++, +−} and F − = {−+, −−}.

Consequently, the natural filtration (as specified in Definition 3.3.2) is

F0 = {∅, Ω},

F1 = {∅, Ω, F+ , F− },

F2 = {all subsets of Ω}.

Proposition 3.3.6. The market M has scenario space Ω = {+, −}T , the set of all
sequences of pluses and minuses of length T . Moreover, there is a riskless asset
bond with rate of return r, and a risky asset stock whose price process evolves
according to the rule

St+1 (ω1 ω2 . . . ωt +) = St (ω1 ω2 . . . ωt )u;

St+1 (ω1 ω2 . . . ωt −) = St (ω1 ω2 . . . ωt )d.

Proposition 3.3.7. If the riskless rate of return is r = 0, then the risk-neutral

probability measure P is the probability measure on Ω under which the coordinate
random variables ξt , defined by

ξt (ω1 ω2 . . . ωT ) = ωt · 1 for t = 1, 2, . . . , T,

are independent and identically distributed, with distribution

1−d
P {ξt = +1} = p and P {ξt = −1} = q := 1 − p where p= ,
u−d

Ft = σ(ξ1 , ξ2 , . . . , ξt ).
 ARBITRAGE AND MARKET DYNAMICS: A PROBABILITY-BASED APPROACH 15

Theorem 3.3.8. Martingale Representation Theorem. If (Yt )0≤t≤T is a mar-

tingale relative to the natural filtration (Ft )0≤t≤T , then (Yt − Y0 )0≤t≤T is a mar-
tingale transform of the Stock price martingale (St )0≤t≤T ; that is, there exists a
predictable sequence (βt )1≤t≤T such that for each t = 1, 2, . . . , T ,
t
X
Yt = Y0 + βj (Sj − Sj−1 ).
j=1

Proof. Fix a scenario ω = ω1 ω2 . . . ωT ∈ Ω and let Gt (ω) be the set of all scenarios
whose first t entries are ω1 ω2 . . . ωt . Since the sequence (Yt )0≤t≤T is a martingale,
it follows that for every t < T and every ω ∈ Ω,
(1) E[Yt+1 1Gt (ω) ] = E[Yt 1Gt (ω) ].
Moreover, since the sequence (Yt )0≤t≤T is adapted to the natural filtration, the
value Yt+1 (ω) − Yt (ω) depends on the scenario ω = ω1 ω2 . . . ωT only through its
first t + 1 entries. Thus, equation (1) implies that, for each t and each ω,
(2) pYt+1 (ω1 ω2 . . . ωt +) + qYt+1 (ω1 ω2 . . . ωt −) = Yt (ω1 ω2 . . . ωt ).
Equation (2) also holds if Yt+1 and Yt are replaced respectively by St+1 and St
because (St )0≤t≤T is also a martingale. Solving both equations for −q/p leads to
the relation:
Yt+1 (ω1 ω2 . . . ωt +) − Yt (ω1 ω2 . . . ωt ) q St+1 (ω1 ω2 . . . ωt +) − St (ω1 ω2 . . . ωt )
=− = ,
Yt+1 (ω1 ω2 . . . ωt −) − Yt (ω1 ω2 . . . ωt ) p St+1 (ω1 ω2 . . . ωt −) − St (ω1 ω2 . . . ωt )
which in turn implies that
Yt+1 (ω1 ω2 . . . ωt +) − Yt (ω1 ω2 . . . ωt ) Yt+1 (ω1 ω2 . . . ωt −) − Yt (ω1 ω2 . . . ωt )
=
(3) St+1 (ω1 ω2 . . . ωt +) − St (ω1 ω2 . . . ωt ) St+1 (ω1 ω2 . . . ωt −) − St (ω1 ω2 . . . ωt )
:= βt (ω1 ω2 . . . ωt ).

Remark that the common value of the fractions on the two sides of equation (3)
depends only on ω1 ω2 . . . ωt , so the definition of βt is valid, which proves Theo-
rem 3.3.8. □

Acknowledgments
It is my pleasure to thank my mentor, Jakob Wellington, for his invaluable
guidance throughout the writing of this paper. I would also like to extend my
thanks to Professor Rudenko for conducting apprentice lectures, especially in group
theory. Special thanks to Professor Lawler for delivering lectures on probability and
analysis. Finally, my sincere appreciation to Professor May for organizing the Math
REU, which allowed me to gain valuable insights into the experience of conducting
mathematical research for the first time.

4. Bibliography
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