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Setting :

• Two periods - now (t = 0) and next period (t = 1). Buy assets for certain prices now and receive uncertain return next period. • Two states of nature next period so gross returns in the two states are represented by 2 x 1 vectors. • • Prices of assets and vectors of returns are denoted by pi and vi respectively. A portfolio consists of a set of asset holdings. The price of a portfolio is just 3i pihi where hi is the holding of asset i. • The cashflow or payoff of the portfolio, which is received in period 1, is uncertain. Suppose there are two assets with payoffs:

Then the payoff vector of the portfolio with h1 = 3 units of asset 1 and h2 = 10 units of asset 2 is:

•

With free portfolio formation, there are no restrictions on how you form a portfolio. In particular, there are no short selling restrictions.

•

We also assume that there are no frictions such as taxes and transaction costs.

If the LOP did not hold. • • An arbitrage opportunity is a zero cost. • . • • Sometimes linear pricing / LOP referred to as the value additivity rule.e. / / In example (3). The notation p(v) denotes the price p at time 0 of an asset with risky cash flows v at time 1. i.e. • Some examples of arbitrage opportunities: • Law of one price does not hold in examples (1) and (2). v2 = 2v1 yet p2 = 2p1.Law of One Price and Arbitrages • Want to obtain a set of criteria for consistently / fairly pricing risky assets. No arbitrage pricing. allows us to do that. linear pricing / the law of one price (LOP) must hold:p("v) = "p(v) p(v1 ± v2) = p(v1) ± p(v2) p("v1 ± $v2) = "p(v1) ± $p(v2) i. the pricing function is linear. risk free profit opportunity. In example (1). ruling out arbitrage opportunities. arbitrage opportunities would exist and these arbitrage opportunities would not be consistent with an equilibrium of some non-satiated agent. In example (2). With free portfolio formation. the law of one price holds since v2 is not proportional to v1. v3 = v1 + v2 yet p3 = p1 + p2.

1 + 1. • In example (4).p1 + 1. .p1 -1.However the portfolio consisting of -1 unit (short sale) of asset one and 1 unit (buy) of asset 2 is a weak arbitrage. Also need to rule strong and weak arbitrages. the portfolio consisting of 10 units of asset 1 and -1 units (short sale) of asset 2 is a strong arbitrage.p2 = -1.p2 = 0 10v1 -1v2 = • These examples show that linear pricing / LOP is necessary but not sufficient to rule out arbitrage opportunities. This portfolio has zero cost and generates a positive payoff in every state of the world: 10. See diagram. This portfolio has zero cost yet the payoff in at least one state is positive and zero in every other state: -1.1 = 0 -1v1 + 1v2 = • A weak arbitrage is a zero cost portfolio that never results in a loss and sometimes result in a gain.

• • Do not need to model supply and demand or preferences! Also used in corporate finance to derive classic Modigliani-Miller result on use of debt versus equity. • For example. “no arbitrage” price. • • No arbitrage opportunities Y law of one price + existence of state prices etc.The Fundamental Theorem of Finance The theorem says that the following conditions are equivalent: (i) (ii) (iii) No arbitrage opportunities. For example. • Can use arbitrage pricing to price new assets with attainable / marketable payoffs ie. risk neutral / no arbitrage pricing used to price contingent claims such as options and futures.e. The existence of strictly positive state prices q or Arrow-Debreu prices such that the current price of a random cash flow next period equals the sum of the cashflows in each state times the state prices. payoffs which can be replicated by some portfolio of existing assets. the payoff and the second state price is the current price of the payoff next period. The equilibrium of a non-satiated agent. the first state price is the current price of the certain payoff of 1 in state 1 and 0 in state 2 next period i. Discussion: • The fundamental theorem is very important because it is the basis of “no arbitrage pricing”.8 = 10¾. • When there are two states. • Equilibrium of some non-satiated agent Y existence of fair / correct. if the state prices q1 = 1¼ and q2 = 1½ then the price of the random cash flow is just 1¼. .-1 + 1½ .

-o0O0o- . These bounds can be useful. you can still derive upper and lower bounds for it’s price. If the asset’s payoff is not attainable.• Attainable payoffs are payoffs which are in the space spanned by the vi which means that they can be expressed as a linear combination of the vi. However. For example. in incomplete markets (markets with more states of the world than assets etc. • • State prices need not be unique.) with no arbitrage. all sets of state prices generate the same price for an asset whose payoffs are attainable. state prices are unique.

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