7. Arbitrage Flashcards
Arbitrate strategies
Patterns of trades motivated by the prospect of profiting from discrepancies between the prices of different assets but without bearing any risk
Arbitrage principle (equilibrium)
Observed market prices reflect the abscence of arbitrage opportunities
Law of one price
A single price elimates arbitrage opportunities
What conditions must an arbitrage portfolio satisfy?
- Zero initial outlay
2. Risk free
What does zero initial outlay mean?
The value of the arbitrage portfolio is equal to the value of the original portfolio
Arbitrage opportunity
A set of asset prices such that an arbitrage portfolio exists and v(x,k)>0 for at least one k
Abscence of arbitrage opportunities
A set of asset prices for which exactly one of the following conditions holds:
- For every arbitrage portfolio v(x,k)=0 in every k
- No arbitrage portfolio exists. That is, for every portfolio requiring zero initial outlay v(x,k)>0 for some k and v(x,k)<0 for some k
Market equilibrium
A set of asset prices and an allocation of asset holdings across investors such that the demand to hold assets is no greater than the supply available
State price
The price of an asset that has a payoff of one unit of wealth in state k and zero in every other state
What is the linear pricing model equivalent to?
A risk free rate of return with associated discount factor and probabilities for each state
When can we achieve full insurance?
When markets are complete
How are equilibrium prices determined?
As if investors are risk neutral with state probabilities determined by state prices
