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North-Holland

**The valuation problem in arbitrage price
**

theory

Stephen A. Clark*

University of Kentucky, Lexington KY, USA

Submitted November 1990, accepted September 1992

**Suppose a continuous, strictly positive, linear price functional p is given on a subspace M of
**

marketed claims. The valuation problem consists of verifying whether or not there exists a

continuous, strictly positive, linear extension of p from M to the entire contingent claims space

X. We solve this problem when X belongs to a large class of Banach lattices including the

classical Banach spaces, and also simplify some analogous results found in the literature for

other types of financial models.

1. Introduction

**This essay aims toward resolving a valuation problem in the foundations
**

of arbitrage price theory. An arbitrage opportunity is essentially a feasible

contingent claim with positive net return across all states of nature. In other

words, an arbitrage is a ‘free lunch’. Financial economists have long

recognized that a competitive market equilibrium eliminates all arbitrage

opportunities and have exploited this condition to evaluate contingent claims

[e.g. see Modigliani and Miller (1958), Merton (1973) or Black and Scholes

(1973)]. In contrast, we follow an axiomatic approach that abstracts away

from general equilibrium theory.

In the next section, we present some basic conditions which describe the

absence of arbitrage opportunities. Suppose the contingent claims space X is

a Hausdorff, locally convex, topological vector lattice and the marketed

claims space M is a subspace of X. Ross (1978) has suggested a key axiom

A.1 of no arbitrage opportunities, formally demanding that there does not

exist a feasible claim in the strictly positive cone. Under a mild auxiliary

condition typically satisfied by a riskless marketed claim, it is straightforward

to verify that A.1 characterizes a strictly positive, linear price functional

p: M-R. This result is the most fundamental and elementary type of

**Correspondence to: Stephen A. Clark, Department of Statistics, University of Kentucky,
**

Lexington, KY 40506-0027, USA.

*The author expresses gratitude to an anonymous referee who detected a logical error in the

original version of this paper.

03044068/93/‘SO6.00 0 1993-Elsevier Science Publishers B.V. All rights reserved

2. By definition. see Harrison and Kreps (1979). which is interpreted as the collection of marketed claims.g.. Clark. A. Recent developments in general equilibrium theory suggest that it would be useful to solve this problem for an arbitrary topological vector lattice [e.5 and A. strictly positive. This result has applications to the theory of continuous trading [e.464 S. locally convex. an assumption that is vital for the implementation of the Radon-Nikodym theorem. which is a weak version of Krep’s (1981) assumption A. for constructing probability measures in terms of a positive linear functional p: M +R which serves as an expectations operator. see Karatzas (1989)].g.3 and A. This lattice operation v creates a natural vector order 2 on .2. providing a computational method for evaluating con- tingent claims.l. This exercise illustrates how subjective probability theory has anticipated the modern development of arbitrage price theory. we introduce the valuation problem.6 are equivalent assumptions for practically all the circumstances where these authors have characterized the existence of a valuation operator. Chamberlain and Rothschild (1983) or Hansen and Richard (1987)]. see Mas-Cole11 (1986) or Zame (1987)]. a topological vector lattice X is a topological vector space equipped with a (uniformly) continuous lattice operation v :X xX+X. 5. In the third section. we completely resolve the valuation problem for the classical Banach spaces Lq(S. Here we show that A.2. These methods do not require separability assumptions.g. we show that A.6 of ‘no free lunches’. In the fourth section. topological vector lattice X.5 completely characterizes the existence of a valuation operator.. Valuation problem in arbitrage price theory arbitrage argument. The latter condition has been utilized by Kreps (1981) and by Duffie and Huang (1986) to solve the valuation problem for a class of models that evoke separability assumptions.1 and A. and a subspace M. Arbitrage equilibrium The formal model consists of a Hausdorff. In the fifth and final section. we discuss the historical connection between arbitrage price theory and subjective probability theory [Ramsey (1926) or De Finetti (1937)]. Its purpose is to assure that the price functional p is also continuous.~) when 154 < a. which is a topological version of A. linear extension of p to the entire contingent claims space X. We only need to slightly weaken our axioms. which is interpreted as the collection of all contingent claims. but Hilbert lattices are especially common in financial modelling [e. to obtain coherency axioms. Then we present another axiom A.A.4. Following Ross (1978) a valuation operator P : X -+[w is a continuous. A fundamental problem of arbitrage price theory is to characterize the existence of a valuation operator. Nevertheless. A. Instead we merely require that p is a CJ- finite countably additive measure on (St). Here we suggest a new axiom AS.

Suppose the market assigns a price pi to the marketed claim m. many of our results generalize to an ordered topological vector space with closed positive cone.B are subsets of X. Clark. For any XE M. We do not need to assume that prices are a priori positive. Indeed..g. let p(x) >O denote the condition 4 >O for every q E p(x). a marketed claim me M is just a portfolio of long and short positions in the available markets. S. A price correspondence p: M+R is naturally defined by the formula p(m) = C &pi : m = C limi for some (2i}i. we now have the following axiom: . however. In summary. The positive cone is given by X+ = {XE X: x20). and antisymmetric.A. X+=X++ u (0). but rather we intend to derive this property as a consequence of the absence of arbitrage opportunities.. for every in I. The vector order 2 is reflexive. we have the defining formula M= x~X:x=~~imiforsome{~i}i~. and A -B = A +(-B).~EB}. We employ the notation m =xie. p(m) represents all possible prices for which the marketed claim m E M can be purchased by constructing it as a portfolio of contingent claims offered directly in the markets. the requirement that M is a subspace assumes frictionless trading. Valuation problem in arbitrage price theory 465 X defined by the condition x1 2x2 if and only if (x1 -x2) v 0=(x. We also let A denote the topological closure of A. In formal terms. Thus. Let F denote the collection of all feasible claims. A+B={x~X:x=a+b for some UEA. Thus. The principle of no arbitrage. We do not necessarily assume. as originally formulated by Ross (1976. and x1 #x2. The strictly positive cone is given by X + + ={xEX:X>O}. Suppose A. asserts that there does not exist a feasible claim in the strictly positive cone X++. that the numbers of markets is finite. there exist markets for only some of the contingent claims in X3 say {miliol. Presumably. Let > denote its asymmetric component. e. We say that a marketed claim me M is feasible provided that there exists some 4 up such that 420. 1978). -x2). Indeed. so that x1 )x2 if and only if x1 2x. Let -A={x~x:-XEA}. The following notation is useful. i iel isl I for every rnE M. A key property of a topological vector lattice is the closedness of X+. transitive. Mimi for a marketed claim with the understanding that the number of shares %i of the claim mi is non-zero in only a finite number of markets. unlimited short selling and no transactions costs. and the collection of marketed claims M is the linear span of {mi}iE. icl Of course. The economic interpretation of this price correspondence is easily explained.

linear functional. > 0. and p(m)#i.m. e.l.2.imi with q= :z. Define a contingent claim . 0 We say that p: M+R is an arbitrage equilibrium whenever p is a stricly positive. then A.x = [I(4 . we show that p: M +R is linear. it is now obvious that A. XEM++. If we momentarily interpret > as a strict preference relation. because (4 .)+3L.l.I.&)m. Let m. This contradicts A. If p is a strictly positive linear functional.1 holds trivially. suppose Y is a subspace of X and p : Y + R is a linear functional on Y. Let Y + = Y n X+ and Y++=YnX++.. Then the absence of arbitrage opportunities implies p is a linear functional. x>O implies p(x)>O. Valuation problem in arbitrage price theory A. assume A.+Ci. Then p(m) is not uniquely deter- mined.q*)/p.1 for the price correspondence p : M -+R. then A. Next.1 represents Harrison and Krep’s (1979) condition of ‘no simple free lunches’. It is straightforward to determine the implications of A. Suppose there exists a marketed claim m.lP. We first show that p(m) is uniquely determined for every rn~ M. contradicting the conclusion reached in the previous paragraph. Then x E M and x = [(q . Proqf. p is a linear functional. (AT.466 S. q* Ep(m) such that q >q*.g.4*)lPolmo + rT.r(. Thus. Conversely. a marketed riskless security. Theorem 1. Furthermore.$. E M+ +. On the contrary. and m=&.m. More generally. We record the following result in order to provide the flavor of an elementary arbitrage argument. Then there exist q. assume m = i.. O=C(q-_*)lP.]m. such that m. On the contrary. Then A.Then p0 >O for any p0 up. Finally.1 holds. We may write m=xiE..lt-~i)PiEP(x) implies x E F. showing that p(m) is uniquely determined for every me M..p(m. assume p(m) is not uniquely determined for some me M.).A *m i with q* =xiEII$pi.1 implies p is strictly positive. For every XEM. and we say that p is strictly positive whenever p(y) >0 for every 4’E y++. Clark. their condition implies A.q*)/pO >O. >O.A. +A. In general. Thus. Suppose Mi + #I$. This terminology is motivated by the well-known connection between a market equilibrium and the absence of arbitrage .1 holds if and only if p: M-+R is a strictly positive linear jiinctionul.p(m. because they assume preferences are strictly montone with respect to 2. We say that p is positive whenever p(y) 20 for every YE y+.

M ‘) = 4.~ [w such that J. lending itself to a similar economic interpretation. suppose an agent in the economy has strictly monotone preferences. convex neighborhood of m. Proof. We write x.+x to denote the convergence of the net {x. The geometric Hahn-Banach theorem now implies there exists a continuous linear functional P : X--f [w such that P(x) 2 0 for every x E C(m.:yEr} in M such that mY-+m. strictly positive linear functional.). 1. We introduce the following axiom in order to eliminate the possibility of approximate arbitrage opportunities. A local definition of j is somewhat complicated by the fact that X does not necessarily have a countable local base. p(m) 20 implies P(m) 2 0. N(m. Its significance is explained by the following result. then A. But F-M+GF implies -SF.) and P(x) 5 0 for every x E F . Replacing m with -m in this implication.2.M + .e. For any rnE M. Thus. Let mOE M++. : r~ r} denote a net in X with directed index set r.1 is a necessary condition for the existence of a compensating equilibrium. The logical form of A. let p(m) ~0 denote the condition q>O for every qEp(m). So we obtain that p : M-R is a strictly positive linear functional from Theorem 1. Conversely.) Vy or and pY+q for every rnE i@.A. Then m.#F.2 holds if and only if p:?a+iw is a continuous.2 is analogous to A. C(m. In general.2 holds.Math C .). p(m) 5 0 implies P(m) 50.)= {y~X:y=Lx for some A>0 and xEN(m. we define another price correspondence p: A?--+!& so that the graph of p is the closure of the graph of p. Clark. It is straightforward to verify that if p is a continuous. i. and 3 { py : y E r} P(m) = (3) in [wsuch that py Ep(m. Notice that A. forcing us to use topological nets instead of topological sequences. Consequently. Furthermore.M ‘) = 4. Theorem 2. we see that for every rnc M. say N(m. let {x.2 holds. S. for every rnE M. A. Then A. Thus. Then. In particular. We next study the continuity of the price system in the relative topology.2 implies A. p: M+[W is locally defined by the condition qER:3{m. Accordingly. such that N(m.: YE r} to the point x E X.) n (F . P(x) 5 0 for every x E F. In particular. Then C(mo)n(F--M+)=4.$F-M+.)}. strictly positive linear functional. Suppose M+ + #$. So there exists an open. For every x E Ji?f. For example.l.because for every rnEF we have q50 for some qEp(m).) denote the convex cone generated by N(m. Valuation problem in arbitrage price theory 467 opportunities [e.g. see Harrison and Kreps (1979)]. -p(m) = 0 implies P(m) =0 for every m E M. assume A. there exists some 3. Let C(m.. Then Fn h?l++ =c#J. Then A. x >O implies p(x) > 0. because otherwise the markets cannot clear.) n (F . m.

Then p(x. the latter principle is practically the same as the concept of strict coherence [Shimony (1955) and Kemeny (1955)]. But x:--+x implies x E F. I. Define &. It immediately follows that p: A+R is a continuous.4.l. because his approach is utility free and closely related to the Ross principle of no arbitrage . for every y E r. 3. Since general equilibrium theory usually relies upon a fixed point theorem or the geometric Hahn- Banach theorem to guarantee the existence of a continuous price functional compatible with a market equilibrium.~M++ shows that 2 #O. --tx. According to De Finetti (1937).g.*) =p(x. We wish to especially focus upon De Finetti’s formulation of the principle of coherence.)-+p(x)=O. say .-i. Thus. E M ‘+. the subjective probability of event E. Suppose E is an event in S.m.e.) ~0. Define XT= x. assume p is not strictly positive.(s) = 1 for every s E E and I.2.: YE T} be a net in M such that x. so that I. Indeed. Finally.A.(s) = 0 for every s $ E. which is another violation of A. denote the indicator function on E.>O for all y sufficiently large. Then there exists some XEM+ + such that @(x)=0. The connection between arbitrage prices and coherent beliefs is clearly seen when we regard the contingent claims space X as a vector lattice of real-valued functions upon a state space S. x E F n M + +. then we immediately obtain a violation of A. Then A.-O.1 implies p(m. :YE f} has a feasible subnet. see Harrison and Kreps (1979)]. Clark.A.)/p(m. where the probability of an event is interpreted as an individual’s degree of belief in its occurrence. we must show that p is strictly positive.) = 0 implies XTE F. Subjective probability theory Much of the recent work in arbitrage price theory was anticipated by Ramsey (1926) and De Finetti (1937) in their classic studies of subjective probability theory. i. Therefore. Furthermore.. Then X~*EM. Then E. On the contrary. can be interpreted as a contingent claim which pays off $1 if event E realizes and SO otherwise. P is continuous on M implies p is continuous. An evaluation at rn. Let {x. Now if {x.) for every y E r. Of course. Let I.468 S. So p(x.=p(x.1 implies p(m. Valuation problem in arbitrage price theory p(m)=U’(m) for every me M [see Kelly and Namioka (1963)]. As before.. strictly positive linear functional.2. the requirement of a continuous arbitrage equilibrium is not an extraordinary theoretical demand [e. 0 We say that p: i%+rW is a continuous arbitrage equilibrium whenever @ is a continuous.)>O for all y sufficiently large in the directed index set r. This contradiction shows that p is strictly positive. let m.. because A. which was later rejected by De Finetti (1972) as a proper foundation for probability theory. E is a subset of S.) - &p(m. p(x. positive linear functional [see Kelly and Namioka (1963)]. and .) > 0.

because otherwise p is not uniquely determined.3 holds if and only if p : M+R is a positive linear functional. x 2 0 implies p(x) 2 0.. Thus. For example. >O for some p0 up. The positivity of p now follows trivially from A. we may view subjective probability theory as the following special case of our general model of financial transactions. Conversely. then it is trivial that A. Suppose we have an algebra r of events in the state space S. Valuation problem in arbitrage price theory 469 rc(E).EM+’ such that p0 > 0 for some p0 up.. Therefore. assume A. Clark. Suppose there exists some mOE M+ + such that p. This contradiction shows that p(m) is uniquely determined for every me M. Then A. i. Contrary to hypothesis. A. Its significance lies in the following result. 0 We remark that the auxiliary condition of Theorem 3. It also follows that p is a linear functional. Of course. = Is as an axiom for the state-space model. On the other hand. Hence. which does not directly evoke the state-space approach.3. We first show p(m) is uniquely determined for every rnE M. We have now constructed a portfolio that violates A.). let p(x) 20 denote the condition that 4 20 for every q Ep(x). is almost always satisfied by m. S. M is the collection of (measurable) simple functions on S. This axiom has been discussed by Varian (1987) in the context of a finite state-space model.. is just the price an individual would be willing to pay for the contingent claim I. If p is a positive linear functional. For every x E M. Then we construct the space of marketed claims M as the span of {I. Then we may purchase m at a low price. and M is a sublattice of X. We introduce the following axiom in order to eliminate the relevant arbitrage opportunities. The above theorem is a modest generalization of De Finetti’s well-known . Proof.3. Z(E) =p(l. probability theory merely requires a positive linear functional instead of a strictly positive one. allowing the possibility that an event EE 5 might be assigned probability zero. and we only provide a summary sketch.3. is interpreted as a riskless asset in the typical securities market model. assume p(m) is not uniquely determined for some rnE M. For any XE M. I.3 holds. sell m at a high price. The demonstration of this theorem is a straightforward modification of the proof to Theorem 1.e. the subjective probability model usually requires SE< with n(S) =p(l..A.: E E 0.3 holds. Theorem 3. This requires a suitable modification of our no arbitrage axioms. and use a positive fraction of the proceeds to purchase shares of m. there exists some m.)= 1 as a normalization constant.

4 directly implies F.A. $ F. say N(x. Define C = C(x. c F.Ji?f+ c F. N(x. we obtain x $ F. but its demonstration requires some delicate modifications. convex neighborhood of x0. Then for any 6 > 0. Assume p(m) = 0 for some m E F.4 holds trivially. Proc$ Assume p: M-+R is a continuous.cF. In particular.)=p(m)-_p(m. positive linear functional.) n (F-M’) = 4.470 S. A.) n (F. A.<).4 holds and F # X if and only if p: h?i--+R is u continuous. . Then C is an open. GF. so that (F.). Indeed. assume A.e. Clark. Let C(x. For any x E M. A. By hypothesis.)<O. We next introduce the following axiom as a topological version of A. We remark that subjective probability theorists traditionally take finite additivity as the key property of a probability measure with countable additivity as an important special case [e. Now A.g.#+. An application of the geometric Hahn-Banach theorem yields the existence of a continuous. =c$ implies C n F. Then A. Since F={x~M:p(x)~0}. convex cone such that CnF-q5.. Hence. see De Finetti (1972)].={x~M:p(x)<0).3 is the defining characteristic of a coherent probability measure rr: 5-R for (S.) + M+.M+)G F. Thus. it is clear that F. Thus. This viewpoint is highlighted by the fact that the proof to Theorem 3 works in an arbitrary vector lattice. non- zero linear functional P : X--+ R such that P(x) 5 0 for every x E F. We claim that F. C(x.3. M+) = 4.3. p(m.4. positive linear functionul.)= -6p(m. Indeed. let p(x) 20 denote the condition qz0 for every REP. Notice that A.EFl. for any XE M. The following result is analogous to Theorem 2.)}. Furthermore.> 0 and XE C(x. see Kyburg and Smokler (1964)]. = 4. Then A..4 implies A.. Suppose there exists some rnOE M+ ’ such that p0 >0 fbr some p0 cp(m. we obtain p(m-_m. Thus. Since p(x) E&X). Next. x $ F. Define F. F.) n (F. because -m. Theorem 4. so that (m-6m. which verities the claim.). Conversely.) = {y E X : y = Ax for some 3. For every x E M.g. observe that C n F. such that N(x.) =pO > 0 implies m. Since F-&i+ IS a convex cone.)EFl. G F.3 is essentially equivalent to his coherency axiom. and P(x) 2 0 for every x E C. i. This verifies that F # X. Valualion problem in arbitrage price theory characterization of subjective probability [e. implies p(x) 20.). Let F. M+) = 4. which asserts that p(x) >O whenever x is both marketable and uniformly positive. there exists some xo$F. Notice that F. x E F implies p(x) 5 0. by virtue of Theorem 3.4 holds and F#X.-. . x 2 0 implies p(x) 2 0. it follows that C(x.. p: M +R is a positive linear functional.={x~M:not @(x)20}.) denote the convex cone generated by N(x.. So there also exists some open.

we can just as well replace it with the condition that there exists some m. $ F. Letting d-+0. so that we might assume p(Z. Clark. it is straightforward to verify that this topology is the same as the weak-star topology. p is also a continuous. E M+ + such that O$p(m. Then A. there exists 1 >O such that /m. Suppose there exists some m.E M++ such that p(m.) > 0.6m.e. p(x) 50 implies P(x) SO.).) >O or just 0 $ p(1. cl). so that p(1.) 50 for every 6 > 0. Let D. Since p is a continuous. real-valued functions on S equipped with the essential supremum norm. {) [Yosida and Hewitt (1952)]. Thus. Let (Ej}jm_ 1 denote a sequence of events in 5 that partitions S. The result follows immediately. 5. S. In view of A. . then m. P is continuous on M implies p is continuous.) 2 p(m. i.4 holds if and only if fp: ii&E4 is a continuous. p are proportional linear functionals on M. is the natural candidate to fulfill both roles. If the markets are incomplete in the sense that G #X. On the other hand. Some additional insight is provided when we study our auxiliary con- ditions in the context of a state-space model. is dominated by a positive scalar multiple of I. is just a convenient combination of the auxiliary condition in Theorem 4 and the condition F#X.~) denote the Banach lattice of all essentially bounded. 5. i. Notice that p(mO) > 0 implies m. The following state-space model is useful in the foundations of probability theory. positive linear functional.lIs2m. Proof.) >O implies p0 > 0 for any p0 Ep(m. suppose we endow X=L”(S. so that the sequence {I&T= 1 converges (monotonely) to I.).4. E M ’ + such that p(m. Notice that Theorem 4 readily applies to this model. measurable. Suppose 5 is a a-algebra of events in S and p is a Lebesgue measure on (S. Let X =L”(S. Then the topological dual of X is isomorphic to the lattice of all tinitely additive. 0 Corollary. A. In summary..). E M satisfies p(mO) > 0.) >O. The argument in the proof of Theorem 2 now applies. 5). signed measures on (S. there exists some m. 4. Since X is the dual of L’(S.~) with the topology of pointwise convergence.4 implies @(Al. Thus. P has the property that for every x E M. positive linear functional [see Kelly and Namioka (1963)]. If m.e.(s)/ 51 for (almost) every s E S. F#X.). i.e.=I. F(m. positive linear functional. In fact.A.) implies that it is impossible to assign subjective probabilities to the events in t such that . Valuation problem in arbitrage price theory 471 Thus P(m.. We now examine the Corollary to Theorem 4 under the presumption that m. then the extra condition F#X is automatically satisfied. Thus. Then mO= I. is (essentially) bounded. In addition. is the weak-star topology.) >O. 0 We remark that the auxiliary condition in this corollary. it follows that P(m) 50 by virtue of the continuity of P. assume some m. showing that P... Notice that O$p(Z.= us= 1 Ej whenever 15 k< co.

Clark. If there exists a net {x. then not x > 0. Therefore. The valuation operator Suppose p : Ii?l+R is a continuous arbitrage equilbrium.3 whenever X is a Banach lattice and the appropriate auxiliary condition holds.6. Then p has a positive linear extension to X provided that M contains a radial point of X+ [see Kelly and Namioka (1963)]. and there exists a net {m. Thus. A.6 is both a necessary and sufficient condition for . when we work in the framework of the weak-star topology. In other words. This property was discussed by De Finetti (1972) to distinguish between finitely additive and countably additive probability measures. In more concise terms. strictly positive. I.: y E r} in F such that my 2 x. which is expressed by the following assumption. We regard A. e.:y~r} in A such that liminf{p(m. a valuation operator is a continuous. a valuation operator is a continuous.: YES} in X such that xy+x for some XEX. for every y E r. p is continuous on M. and fi is continuous on ii%. Suppose p: M +[w is a (strictly) positive linear functional.g. the provision of conditions for the existence of a valuation operator is a vital problem in financial economics. Kreps demonstrates that A. continuity does not pose a special problem when X is a Banach lattice for the following reason. This concept was introduced by Ross (1976.). notice that the continuity of p: M-+LQ implies that n is countably additive. A fortiori. If there exists a net {x. see Harrison and Kreps (1979) or Duffie and Huang (1986)].4 from A.g. In general. Yet a positive linear functional P on a Banach lattice X is necessarily continuous [see Schaeffer (1974)]. for every y E r. then not x>O.A.472 S. Valuation problem in arbitrage price theory rc(Ej) = 0 whenever 15 j < co and rr(S) = 1. we may deduce A. it plays a key role in the construction of an equivalent martingale measure for a dynamic model of the securities markets [e. 4. linear functional P:X-+R such that the restriction of P to the subspace M is identical to p. E M and 1 E ~(1. and there exists a net (m. Furthermore. In forma1 terms. It is straightforward to verify that the following condition is necessary for the existence of a valuation operator.5 as a weak version of Krep’s (1981) condition of ‘no free lunches’. strictly positive. A. this axiom asserts that X+ + n (F-X’) = 4.5.): YES} 50 and my 2 x. linear extension of p to the entire contingent claims space X. 1978) in order to provide a computational approach to arbitrage price theory.:y~r} in X such that x7-+x for some XEX. More importantly.

Nevertheless. non-zero linear functional P. Notice that IIPxl[>O. i.(y) 50 for every YE K. there exists an open. Theorem 5. e. In summary. Hence.e.6 can be replaced with A.A. Clark. B*={PEX*:IIPII~~}. 9 also satisfies the second axiom of countability. weak-star dense subset of 9.g. we claim that A.}.5. such that N(x) n (K-J) = 4. which implies P. Let X* denote the (topological) dual of X. Now P.“_. by renormalization if necessary.(y) 2 0 for every y E J. assume J n (K . Proof. : X-t R such that (i) P. convex neighborhood of x.(x) for every XEX. It is more convenient here to focus upon general methods. Without loss of generality. to show that A. because C(x) is open and x E C(x). We now define a linear functional P:X+R by the formula P(x)= XI’= 1 2_‘Px.J)=4.}~l . Then for every x E J. i. So an application of the geometric Hahn-Banach theorem yields the existence of a continuous. Duffie and Huang (1986) derive the same type of result whenever X is a separable Banach space.“= 1 is a Cauchy sequence in the Banach space X*. for every x E J.(y) 5 0 for every y E K.(y) 2 0 for every y E J. see Dunford and Schwartz (1971)]..J)=#. and let B* denote the unit ball in X*.5 and A. It follows that B* satisfies the second axiom of countability in the relative weak-star topology. (ii) P. Then there exists a continuous linear functional P : X-+ R such that P(x) > 0 for every x E J and P(x) 5 0 for every XEK ifand only ifJn(K-J)=$.: X-R such that P. there exists a continuous linear functional P. It is straight- forward to verify that C(x) is an open. it is clear that P(x) 50 for every XE K. we may also assume that (iv) IIPxll= 1 for every XE J. Furthermore.6 are equivalent conditions under all the circumstances for which these authors have characterized the existence of a valuation operator. Suppose J. Let Y= {Px: x E J}. convex cone such that C(x) n K =c$. K are non-empty convex cones (with vertices at the origin) in a separable Banach space X. Furthermore. say N(x). S. denote a countable. rather than attempting a tedious replication of their arguments. Let {Pxi>.g. and hence Y is weak-star separable. Conversely. Valuation problem in arbitrage price theory 413 the existence of a valuation operator whenever the contingent claims space X has an appropriate structure. B* is metrizable with respect to the relative weak-star topology [e. and (iii) P. P. Since {Px.(x) > 0. we offer the following strict separation theorem. then J n (K. S’mce X is a separable Banach space.(x)>O. X is normable and its dual space has weak- star separable subsets. C(x) = {z~X:z=Ay for some 2~0 and some YE J+N(x)}. Since 9~ B*. It is straightforward to verify that if there exists a continuous linear functional P: X+R such that P(x) > 0 for every x E J and P(x) 5 0 for every XEK. Let C(x) be the convex cone generated by J + N(x).(y) 20 for every y E C(x).(y) 2 0 for every YE C(x) and P. Then P is a well-defined continuous linear functional because {x1= I 2 -‘P.e.

So we may assume P extends p without loss of generality.l.-+x. 5). lf J n K = {0}. the condition P(x) 5 0 for every x E F implies P and p are proportional linear functionals on J@ (recall the argument in the proof to Theorem 2).(x)>0 and P(x)>0 for every xEJ. Let 5 denote a a-algrebra on S..l.6 with A. Lemmu. Therefore. P. Suppose J is u polyhedral cone and K is a closed convex cone in a Hausdorjji locally convex. Theorem 3). we are heavily indebted to Kreps. Although it may appear that A. A. Valuation problem in arbitrage price theory is weak-star dense in 9.(x)/2. these axioms are actually equivalent under various circumstances. then the state space S is finite dimensional and. They analyze a dynamic securities market model whose contingent claims space X is a L’ probability space. and let rr denote a countably additive probability measure on (S.(x)/ <P. We present the following lemma in order to establish their equivalence in the case when M is finite-dimensional.5 and A.5 is stronger than A. We want to show that XEK-J. topological vector space X. It is straightforward to verify that the proof to Theorem 5 remains valid when we replace the hypothesis that X is separable with the hypothesis that X* has weak-star separable subsets. there exists some positive integer i such that II’. As pointed out by Duffte and Huang (1986) the contingent claims space X=L’(S.5 under all the circumstances for which he has verified the existence of a valuation operator. then the condition J n (K -J) =4 is equivalent to axiom A. If we select J =X+ + and K = F. because the latter half of the proof to Theorem 5 is a simple adaptation of his methods. If we identify a state of nature as a realized stream of net return vectors. then K-J is a closed convex cone.414 S.}~=r of non-zero vectors such that x EJ if and only if x=~~~= 1Ai. . Indeed. Let {X~:YE T} be a topological net in K-J such that x.5.(x)--P.A. 0 The significance of the above theorem to arbitrage price theory can be explained as follows. Suppose a tinite number of securities can be traded at only a finite number of dates. Recall that a polyhedral cone J by definition has a finite base (j.~) is a separable Banach space. This result generalizes an analogous proposition due to Kreps (1981. it follows that for every XEJ.ji some sequence {Ii}:= 1 of non-negative real numbers. Thus. The analogous result by Duffte and Huang (1986) is an immediate corollary. Another important issue is the relation between A. Proof We demonstrate this result by induction on the dimension n of the base {ji}l= 1 for J. First assume n= 1 and J n K = (0). we may replace A. Furthermore. separable. A similar technique was employed by Duffie and Huang (1986). 5. Clark.. hence.5 characterizes the existence of a valuation operator whenever X is a separable Banach space. Nevertheless. so that Theorem 5 readily applies.

This verities the lemma in the case n = 1. so that X++ n(F-X+)=4. with base of dimension n. by passing to a subnet if necessary.5 asserts X+ + n (F-X+)=4. Proof.) = (0) implies (K-J. A potential gap is suggested by comparing Theorems 1 and 2. the previous lemma implies (F-X+) = F-X+. we obtain the contradiction j. Recall that A. because K is closed. but we have nothing else to offer besides Theorem 6 for closing it in this paper.-I../l. It follows that x + nj. But k.2 and AS.1 does not generally imply the existence of a valuation operator. E K and K is closed implies j. On the contrary. Therefore. Then A.=k.) . In the context of dynamic securities models.+. =O. Conversely.}~=. = K . We claim that {x?:y~Z’} is bounded. Then F n X+ = (0). 0 This theorem is readily applied to a finite state-space model consisting of only a finite number of markets.1 in this situation.1 is equivalent to A. cl Theorem 6.=x. J. Valuation problem in arbitrage price theory 475 Since x. by passing to a subnet if necessary.5 is equivalent to A.. Another potential gap exists between A. k. + J. J. On the other hand. Assume J is a polyhedral cone with base {ji}lZf of dimension n+ 1 such that J n K= (0). be the polyhedral cone with base {j “+i}./2.. so that the inductive hypothesis implies (K-J. Consider the identity x. In view of Theorem 5./E. Since xy+x and . notice that the existence of a valuation operator is completely characterized by the simplest arbitrage axiom A.ll. We may now assume A. Then k.A. n (K-J. if M is a closed sublattice of a Banach lattice X.)= (0). for some k.J.. Furthermore. M is finite-dimensional and F is a half-space in M implies F= F is a polyhedral cone.2.. Thus. = k for some k E K.1 asserts F n X+ + =c$ and that A. Then J= J.EK-J.+ cc and 1. The inductive step proceeds as follows. Finally.ZO. Assume the result is true for a polyhedral cone J.++co.1for some AZ0 without loss of generality. and let J.+ j. see Schaeffer (1974). Since J n K = (O}.. implies J. x = k -lj. Suppose M is a finite-dimensional subspace of X.+0. assume {x?:YE~} is unbounded.. Back and Pliska (1991) have constructed a counterexample which shows that A. n K = {0}. be the polyhedral cone with base {j. This contradiction shows that (1.j. Thus. Notice that J.: y E r} is bonded.EK and n.Math D .. because FE(-).g.l. Then we assume I. it follows that x. Clark. we may write x. which implies that a strictly positive price functional p: M+lR is not necessarily continuous.= k.--+.. S. It is obvious that X++n(F-X+)=4 implies FnX++=4.J./.j. implies x E K -J.J is a closed convex cone. then p is continuous [e. E K.I. Thus. > 0 for every y E r without loss of generality. so that A. it is straightforward to verify that F n X+ + =$ implies X ++ n(F-X+)=4. assume F n X+ + = 4. -+x+ nj.$. j. n (K.) is a closed convex cone. Let J.

These spaces have a number of well-known features which make them attractive for financial modelling [e. <) is a Bowl measurable space. n) is fixed and l/p+ l/q= 1. In the framework of a dynamic securities market. see Dunford and Schwartz (1971)]. (n). Notice that J:/I’(I.e. then we encounter an inseparable state space [Billingsley (1968)]. /I is a finitely additive probability measure. Obviously. and the countable additivity of 11 is easil! derived from the representation and the Lebesgue monotone convergence theorem. Clark. where (S. For example.) for every event EEL. Z) is the contingent claims space.g.s. so that Lq(S. It is noteworthy that this space is separable [e. <) by the formula p(E)= P(I. we obtain for every m E M. If P is a valuation operator. . see Billingsley (1968)]. it follows that /1 and 71 are equivalent. a simple model for one-dimensional Brownian motion specifies S as the collection of all continuous functions on [O.A. The state space S is often taken to be all realizable streams of security prices over a finite time interval [0. they are mutually absolutely continuous. these properties imply /L is an equivalent martingale measure [e. Suppose X=Lq(S. 7c is a countably additive probability measure on (S.476 S. On the other hand if we take S as the collection of all right-continuous. left-limit functions on [O. T] endowed with the uniform metric topology. Thrown 7. Since dp/dn >O a. p): where (S. n) is also separable whenever 1 zq < Y. According to the Riesz representation theorem. Further- more. a continuous linear func- tional P: X+Iw has the representation P(x) =jx~ld~. it points toward the importance of solving the valuation problem in an inseparable topological vector lattice. and 15 q < co. r] endowed with a suitable metric topology. see Harrison and Kreps (1979) or Duffie and Huang (1986)]. where y E L. 4. i) is a Bore1 measurable state space. T] endowed with the uniform metric topology. Suppose X = Lq(S. so that p is normalized into a p-expectations operator. i. Define another measure p on (S.n).r). Theorem 5 applies and the existence of a valuation operator is characterized by A.)/P(Z. 5. t.g. 5.s. Then r can be taken as the predictable a-algebra generated by the natural filtration on S. t). Hence.5. Although this difficulty is sometimes avoided by working with the Skohorod topology. <. Classical Banach spaces Consider a classical Banach space Lq(S. then the strict positivitl of P further implies y>O a.g. (7~).~) is the Radon-Nikodym derivative dp/drc. Valuation problem in arbitrage price them) 5.P(S. and imposes the Wiener measure 7-r on (S.

5 holds. Thus. positive linear functional extending p (see the last paragraph of the proof of Theorem 5).:X+[w extending p such that 11 Pxll = 1 and P.~L~(S.) >O and xz6. finite measure A.(x) for every XEX. Clearly. a valuation operator. P(x) ~2-‘PxI(x) ~0. we might impose the weak-star topology on L”(S.(x) = s x d&. the Riesz representation theorem implies that for every x E X+ + the linear functional P. The definition of the Lebesgue integral now implies there exists E. rr) [e. 5. : 15 i < cc ). We now define a linear functional P:X-+R by the formula P(x)= xi”= 1 2_‘P. The necessity of A. r. and 1 sq < co.g. rr). P.(E) =Px(I. = 6. Then a weak-star continuous linear functional P : X+ R has the representation P(x) =j xy dn for some fixed y E L’(S.x. 5.... rc). strictly positive. P is a well-defined. Therefore.) for every E E l. Indeed. which asserts that a family of countably additive measures is dominated by a a-finite countably additive measure if and only if there exists a countable equivalent subfamily [Halmos and Savage (1949)]. we have elected to express Theorem 7 in terms of a a-finite measure in order to make the method of proof more transparent.p).5 is obvious. hence.(y) = l yzx d/l = 1 y d2.r(E. Neither Theorem 5 nor Theorem 7 effectively handle the inseparable Banach space X=L”(S.E < and a positive number fi.. 2 j fi. n) is the dual of L’(S.lEx di. A. The fact that a a-finite countably additive measure is equivalent to a countably additive probability measure is well-known and easy to verify. on (S. such that &(E. 5. Although n is usually assumed to be a probability measure in financial modelling.. Then p admits a valuation operator if and only tf condition A. Notice that P. Nevertheless.) > 0 for some 15 i < a. so we turn to its sufficiency.. say {i. 4) defined by E. It utilizes the Halmos-Savage theorem.(x) >O.1Ex.s.A. Proof. Further suppose p : M-+R is a continuous. Valuation problem in arbitrage price theory 471 p is a a-finite countable additive measure on (S. It follows that &(I?. Thus.(E) = 0 for every 15 i < CC. The method explain in the first paragraph of Theorem 5 shows that for every XEX++ there exists a positive linear functional P. . and that P.(E) = 0 for every x E X + + if and only if i. see Kelly and Namioka (1963. where l/p+l/q=l. 0. for some z. S.i. linear price functional on the subspace M of marketed claims in X. 0 The proof to the above theorem has a measure-theoretic flavor in contrast to the purely geometric flavor of the proof to Theorem 5.5 holds. Assume A... We claim that P is strictly positive and. Clark. exploiting the fact that L”(S.(x)=jxd&>O. the Halmos- Savage theorem [see Halmos and Savage (1949.: X--+R has the representation P. Lemma 7)] implies there exists a countable equivalent subfamily. induces a countably additive. 5. Since the family {i_: x E X + + } is dominated by p.7~) endowed with the essential supremum norm topology.) >O.

P. MA). Huntington. Annals of Mathematical Statistics 20. 1974. 1221-1259.J. Mas-Colell. Convergence of probability measures (Wiley. A. 1039-1053. Journal of Symbolic Logic 20. and C. 1978. Pliska. Coherence and the axioms of conlirmation. Application of the Radon-Nikodym theorem to the theory of sufficient statistics. 1949.. I. Ross. induction and statistics (Wiley.M. Vol. Journal of Business 51. Varian.. The pricing of options and corporate liabilities. Journal of Economic Theory 20. The arbitrage principle in Iinancial economics.. Kreps. Dunford. and SF.5 characterizes the existence of a valuation operator. Journal of Political Economy 3. New York). 1-18. New York). Arbitrage. NY) 19641. and S.. H. Miller. no. Foresight: Its logical laws. M. 1955. 6. S. 1981. l-28. 3. Halmos. D. 225-241. Linear operators. Optimization problems in the theory of continuous trading. again showing that A. Chamberlain. 1989. Journal of Mathematical Economics.C. American Economic Review 48. 1976. F.P. Annales de ‘l’lnstitute Henri Poincare 7 [Reprinted in: H. 15-35. 1952. no. eds. 1987. 55-72. Studies in subjective probability (Krieger. Kyburg and H. The price equilibrium existence problem in topological vector lattices. Ramsey. W. no. Arbitrage and equilibrium in economies with infinitely many commodities. Journal of Economic Perspectives 1. and M.. Hewitt. and arbitrage. Truth and probability [Reprinted in: H... 1987. H. Schaeffer. return. 1991. 261-297. 1963. A simple approach to the valuation of risky streams. The theory of rational option pricing.J. Bell Journal of Economics and Management Science 4.. Kelly. 1986. On the fundamental theorem of asset pricing with an inlinite state space. Black. 1281-1304. SIAM Journal of Control and Optimization 27. corpoi_. Econometrica 54. Hansen.E. Studies in subjective probability (Krieger. no.L. and J. G. De Finetti. Fair bets and inductive probabilities. Ross. 1972..E. Huntington. Clark. B.R. 1926. The cost of capital. Modigliani. 1987. no. S. De Finetti. DufIie. L. Merton.R. Banach lattices and positive operators (Springer-Verlag. 1075-l 108. NJ). 1. no. 453485. R. and E. Princeton. Transactions of the American Mathematical Society 72. K. Harrison. The method of proof for Theorem 7 is easily adopted to handle this situation. Savage. 1937. its subjective sources. eds.478 S. and M. 283-303. Martingales and arbitrage in multiperiod securities markets. The role of conditioning information in deducing testable restrictions implied by dynamic asset pricing models.. 1964. Probability. and I. Cambridge. Bicksler. F.M. Multiperiod security markets with differential information. Journal of Mathematical Economics 15. Kemeny. Studies in subjective probability (Krieger.. eds.R. . Smokler. 1983. 3. D. Journal of Mathematical Economics 20. 263-273.. Richard. Risk. and mean-variance analysis on large asset markets. and H. Econometrica 55. Shimony. NY) 19641. A. Linear topological spaces (Van Nostrand..T.E. B. Competitive equilibria in production economies with an intinite dimensional commodity space. Risk and return in finance (Ballinger. 1971.A. Namioka. Karatzas. 5877613. P.R. Econometrica 55. Smokier. Valuation problem in arbitrage price theory ch. New York).E. Friend and J.e finance and the theory of investment. Kyburg.. 2. 1958. Schwartz. N. Billingsley. 1979. Scholes. 4666. 1973. and L. Kyburg akid H. Huang.. Yosida. 5. and D. 637-654. 1973. Rothschild.. NY). Huntington. F. Zame. References Back. H. Econometrica 51. 381408. 5. factor structure.E. in: I. 141-183. J. Kreps. 1955.E. Smokler.P. no. K.. Journal of Symbolic Logic 20.. Finitely additive measures. 1 (Interscience. 1968. New York). 1986. 5)]. J. and M.

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