Static Arbitrage

University of Geneva
One-Period Model of Financial Markets
1 / 56
Outline
Present simple framework to study fundamental problems in Finance:
The model: One period, finite number of states
The problems:
Risk Hedging
Introduce concept of Payoff Replication.
Asset Pricing
Introduce concepts of Arbitrage and State Prices.
2 / 56
Finance Terminology
Asset: Represents possible future economic benefit.
Security: An investment instrument issued by an organization.

Broadly categorized into debt and equity.
Debt: Entitles holder to payment of principal and interest.

May be protected by collateral (secured) or not (unsecured).
If unsecured, may be “senior” (have higher repayment priority)
to “junior” (or “subordinated”) debt.
Equity: Entitles holder to a share (fraction) of the company’s

stock, profits, and control of a company.
Note: In bankruptcy, debt-holders take control.

Equity-holders receive residual value after all obligations are paid.
3 / 56
Finance Terminology (continued)

Price (value) = amount for which an asset can be exchanged
Payoff = amount of money one receives by owning the security

= Price sold (+ dividends, etc.)
Return = Payoff / Price paid
Risk-free asset: Whose future payoff is known with certainty

Usually government bond with short maturity
Risk-free interest rate: Return of risk-free asset
Risky asset: Whose future payoff is not known with certainty, random
Portfolio: Collection of investments held by institution or individual
4 / 56

Derivative: Security whose value depends on “underlying” security
Option: Derivative that entitles holder to the right to buy (“call”)
or sell (“put”) the underlying security, at specified price
Denote: S the price of the underlying security
K the strike price
C, P the price of a call and put option, respectively
Payoff of call is max {S − K, 0}. Payoff of put is max {K − S, 0}.
Payoff diagrams on expiration date, for call and put:
C P
S S
5 / 56

Derivative: Security whose value depends on “underlying” security
Option: Derivative that entitles holder to the right to buy (“call”)
or sell (“put”) the underlying security, at specified price
Denote: S the price of the underlying security
K the strike price
C, P the price of a call and put option, respectively
Payoff of call is max {S − K, 0}. Payoff of put is max {K − S, 0}.
Payoff diagrams on expiration date, for call and put:
C P
K S K S
6 / 56
Finite-state, One-period model

Two dates, e.g., today (date 0) & tomorrow (date 1).
Note the two dates define one period; hence one-period model.
Finite number of states of the world

E.g., war / no war
good news / no news / bad news
Price of asset today is known, but payoff tomorrow is uncertain.

Additional Assumptions
Units of assets can be sub-divided for sale/purchase
No transaction costs (e.g., no bid/ask spread).
7 / 56
Finite-state, One-period model

Departs from reality:
Small # of states don’t accurately describe world.
World isn’t at standstill between today and tomorrow.
We don’t really know the true probabilities.
Transaction costs cannot be ignored.
So why study it?

Simple(st) model of risky stock prices (returns).
Powerful tool to understand asset pricing.
Building block of dynamic multi-period models.
8 / 56
Introductory Example - Scenario

We want to study a market with 4 assets:
Risk-free asset with certain value 1 tomorrow.
Stock with uncertain value tomorrow.
Stock value tomorrow = 3, 2, or 1 with probability 1/2, 1/6, and 1/3.
Two derivative securities - options, with uncertain value tomorrow
Call Option #1 struck at K = 1.5.
Call Option #2 struck at K = 1 .
Probability
1 1 1
2 6 3
Bond 1 1 1
Stock 3 2 1
Asset payoffs
Call Option #1 (K = 1.5) 1.5 0.5 0
Call Option #2 (K = 1) 2 1 0
9 / 56
Using Matrices to Represent Model

Matrices are very useful in finite-state asset pricing models:
Use vectors/matrices to compactly represent payoffs, prices, etc.
Use matrix algebra to simplify and speed up calculations.
Use matrix theory to relate finance and mathematical concepts
⇒ gain valuable intuition
10 / 56
Payoffs as Vectors
Remember the payoff of asset i is random.
Useful to represent payoff of asset i as m×1 vector, ai ; m is # of states

m−tuple of numbers, each corresponding to payoff in a state.
       
1 3 1.5 2
In example: a1 = 1 , a2 = 2 , a3 = 0.5 , a4 = 1 .
1 1 0 0
11 / 56
Operations on Securities/Vectors
 
λa1
Scalar multiplication: For λ ∈ R, we have λa =  . . . .
λam
   
2 × 1.5 3
Example – Buy two units of option #1: 2a3 = 2 × 0.5 = 1.
2×0 0
 
a11 + a21
Addition: a1 + a2 =  ... .
a1m + a2m
Example – Buy two options #1, issue/sell one option #2:

     
1.5 2 1
2a3 − a4 = 2 0.5 − 1 = 0.
0 0 0
12 / 56
Matrix as a collection of securities/vectors

Form payoff matrix, containing the payoffs of all securities
In our example:
       
1 3 1.5 2
a1 = 1 , a2 = 2 , a3 = 0.5 , a4 = 1,
1 1 0 0
 
1 3 1.5 2
A = 1 2 0.5 1.
1 1 0 0
Note that in matrix A:

A row corresponds to payoffs in a specific state of the world,
one element for each security.
A column corresponds to payoffs of an individual security,
one element for each state of the world.
13 / 56
Reminder - Matrix Multiplication

If A is r × k and B is k × s, so that the number of columns of A equals
the number of rows of B; we say that A and B are conformable.
In this event, the matrix product AB is defined, writing A as a set of row
vectors and B as a set of column vectors (each of length k) as:
 
a1·
a2· 
AB =  .  b·1 b·2 · · · b·s
 
 ..  B
ar·
 
a1· b·1 a1· b·2 · · · a1· b·s
a2· b·1 a2· b·2 · · · a2· b·s 
=  . ..  .
 
.. ..
 .. . . .  A
ar· b·1 ar· b·2 · · · ar· b·s
14 / 56
Matrix Multiplication and Portfolio Payoffs

Represent portfolio holdings as n×1 vector, x; n is # of basis assets.
n−tuple of numbers, each corresponding to amount of asset held.
 
1
−1
Examples: x = 1 , or x = .
2
1
Portfolio payoffs calculated multiplying payoff matrix with portfolio vector.
Example: Issue 2 units of option #1, 1 unit of option #2, buy 2 units
of the stock and sell 
1 unit
 of risk-free security:
  −1  
1 3 1.5 2   0
1 2 0.5 1  2  = 1
−2
1 1 0 0 1
−1
A x Ax
Portfolio payoff = Ax.
15 / 56
Matrix Multiplication and Portfolio Prices

Represent asset prices as n×1 vector, S; n is # of basis assets.
n−tuple of numbers, each corresponding to price of an asset.
 
1
2
Examples: S = 2 , or S = .
5
3
Portfolio price calculated by multiplying price vector with portfolio vector.
Example: Issue 2 units option #1 at $0.5, 1 unit of option #2 at $1,
buy 2 stocks at $2 each,
 and sell 1 unit of risk-free security at $1:
−1
 2
1 2 0.5 1  −2 = 1 · (−1) + 2 · 2 + 0.5 · (−2) + 1 · (−1) = 1.

−1
S0 x S0 x
0
Portfolio price = S x.
16 / 56
Model Representation - Exercise

We want to study a market with 3 assets:
Risk-free asset with certain value 1 tomorrow.
Stock with uncertain value tomorrow.
Stock value tomorrow = 1, 5, or 2 with probability 1/4, 1/4, and 1/2.
One derivative security - option, with uncertain value tomorrow.
Put Option struck at K = 2 .
Find the following:

1. What is the payoff matrix?
2. What is the payoff of holding 1 unit of each asset in the market?
3. If prices are $1, $3, and $0.25, what is the price of this portfolio?
17 / 56
Model Representation - Exercise - Solution

It helps to create the following table: Probability
1 1 1
4 4 2
Asset payoffs Bond 1 1 1

Stock 1 5 2
Put Option (K = 2) 1 0 0
1. What is the payoff matrix?
18 / 56

1 1 1
4 4 2

Stock 1 5 2
1. What is the payoff matrix?  
1 1 1
The payoff matrix is A = 1 5 0.
1 2 0
18 / 56

1 1 1
4 4 2

Stock 1 5 2
1 1 1
1 2 0

   
1 3
The portfolio vector is x = 1, so the payoff vector is Ax = 6.
1 3
3. If prices are $1, $3, and $0.25, what is the price of this portfolio?
18 / 56

1 1 1
4 4 2

Stock 1 5 2
1 1 1
1 2 0

   
1 3
The portfolio vector is x = 1, so the payoff vector is Ax = 6.
1 3
3. If prices are $1, $3, and $0.25,
 what
 is the price of this portfolio?
1
The price vector is S =  3 , so the price of x is S0 x = 4.25.
0.25
18 / 56
The Problems
Risk Hedging
Entity has a risky payoff, and wants to reduce/eliminate risk.
Client of investment bank needs security with some payoff.
Investment bank offers to create and sell this new security.
But it doesn’t want to carry the risk, i.e., it wants to hedge risk.
⇒ Introduce Payoff Replication
Asset Pricing
Client of investment bank needs security with some payoff.
Investment bank needs to determine at what price it should sell.
⇒ Introduce Arbitrage & State Prices.
19 / 56
The General Problem

Consider the following setup:
Let A be the m × n payoff matrix of basis assets in the market.
Let b be a m × 1 payoff vector.
We want to find the n × 1 portfolio vector, x, such that Ax = b.

When is it possible to find x such that Ax = b?
How do we calculate x?
The interpretation of b and x depends on the problem we consider:

Risk Hedging: b is payoff to be hedged; x is hedging portfolio.
Asset Pricing: b is focus asset to be priced; x is replicating portfolio.
20 / 56
System of Equations
It is often useful to think of alternative representations of Ax = b.
It is equivalent to:
       
A11 A12 A1n b1
 A21   A22   A2n   b2 
 ..  x1 +  ..  x2 + . . . +  ..  xn =  ..  , and
       
 .   .   .   . 
Am1 Am2 Amn bm
A11 x1 + A12 x2 + . . . + A1n xn = b1

A21 x1 + A22 x2 + . . . + A2n xn = b2
···
Am1 x1 + Am2 x2 + . . . + Amn xn = bm
21 / 56
Reminder - Calculating Inverse of 2 × 2 Matrix

a11 a12
A=
a21 a22

1 a22 −a12
A−1 =
|A| −a21 a11
where |A| = a11 a22 − a21 a12 .

4 3
Example: Find the inverse of A = .
3 2

−1 −2 3
A =
3 −4
22 / 56
Reminder - Calculating Inverse of 3 × 3 Matrix
   T
a11 a12 a13 C C12 C13
1  11
A = a21 a22 a23  A−1 = C21 C22 C23 
|A|
a31 a32 a33 C31 C32 C33
where
 
a11 · · · a1j · · · a1k
 .. .. . .. .. 
 . . .. . . 
Cij = (−1)i+j
 
 ai1 · · · aij · · · aik 
 .. . .. 
 
.. ..
 . . .. . . 
ar1 · · · arj · · · ark
and
n
X
|A| = a1j C1j
j=1
23 / 56
Calculating Inverse of 3 × 3 Matrix - Example

 
1 3 1
Find the inverse of A = 1 2 1.
1 1 0
 
−1 1 1
A−1 =  1 −1 0
−1 2 −1
24 / 56
Reminder - Calculating Inverse of n × n Matrix

General method for finding inverse A−1 is Gauss-Jordan elimination.
This method consists of
augmenting the matrix A with the identity matrix to get:
 
a11 a12 · · · a1k 1 0 · · · 0
a21 a22
 · · · a2k 0 1 · · · 0 
 .. .. .. .. .. .. . . .. 
 . . . . . . . .
ar1 ar2 · · · ark 0 0 · · · 1
doing elementary row operations on the augmented matrix:

row multiplication/addition
row switching
until left half of augmented matrix has been turned into the identity.
25 / 56
The Hedging Problem - Example

Setup:
Basis assets: Risk-free asset, stock, option #1.
Payoff to be hedged: Payoff of option #2.
So:          
1 3 1.5 1 3 1.5 2
a1 = 1 , a2 = 2 , a3 = 0.5 , A = 1 2 0.5 , b = 1 .
1 1 0 1 1 0 0
We want to solve Ax = b:
Remember that a unique solution exists iff A is invertible.
 
−1
Indeed A is invertible, so we find x = A−1 b =  1 .
0
       
A11 A12 A1n b1
 A21   A22   A2n   b2 
May be easier to solve  . x1 +  . x2 + . . .+  . xn = . .
       
 ..   ..   ..   .. 
Am1 Am2 Amn bm
26 / 56
The Hedging Problem - Examples of Complications

Swap options #1 and #2: Solve A·1 A·2 A·4 x= A·3 .
bond stock option#2 option #1
No solution exists:
1 × x1 + 3 × x2 + 2 × x3 = 1.5
1 × x1 + 2 × x2 + 1 × x3 = 0.5
1 × x1 + 1 × x2 + 0 × x3 = 0
Consider solving A·1 A·2 x = A·4 .
Solution exists:
1 × x1 + 3 × x2 = 2
1 × x1 + 2 × x2 = 1
1 × x1 + 1 × x2 = 0
Clearly, having as many basis assets as states is neither a sufficient nor a
necessary condition, to find a solution.
27 / 56
The Hedging Problem - Examples of Complications
0
Consider solving A·1 A·2 A·3 A·4 x = 1 2 3 .
Solution exists:
1 × x1 + 3 × x2 + 1.5 × x3 + 2 × x4 = 1
1 × x1 + 2 × x2 + 0.5 × x3 + 1 × x4 = 2
1 × x1 + 1 × x2 + 0 × x3 + 0 × x4 = 3
Clearly, having too many assets can also cause a problem, because we
can’t simply write x = A−1 b, since A is not square, so it isn’t invertible.
28 / 56
Linear Independence
Complications in hedging problem caused by having “few” assets
“Few” basis assets ⇒ can’t write focus asset payoff as portfolio payoff
of basis assets
Securities A·1 , . . . , A·n are linearly independent if all non-zero

portfolios of these assets have non-zero payoff, i.e., 6 ∃x 6= 0 such that:
A·1 x1 + A·2 x2 + . . . + A·n xn = 0.
An alternative way to say this is that the assets are linearly independent if
none of them is a portfolio payoff of the other assets.
29 / 56
Example - Linearly Independent Assets

Consider the market with basis assets whose payoff matrix is
 
1 0 3
A= 2  3 −1 .
3 1 2
How many linearly independent assets are there?
30 / 56
Solution
Columns 1 and 2 clearly linearly independent.
31 / 56
Solution
Check if 3 is linear combination of the others, i.e., find x1 , x2 ∈ R s.t.
A·1 x1 + A·2 x2 = A·3 .
31 / 56
Solution
A·1 x1 + A·2 x2 = A·3 .
We need to solve system of equations
1 · x1 + 0 · x2 = 3
2 · x1 + 3 · x2 = −1
3 · x1 + 1 · x2 = 2
31 / 56
Solution
A·1 x1 + A·2 x2 = A·3 .
1 · x1 + 0 · x2 = 3
2 · x1 + 3 · x2 = −1
3 · x1 + 1 · x2 = 2
We get x1 = 3, and so x2 = − 73 .
31 / 56
Solution
A·1 x1 + A·2 x2 = A·3 .
1 · x1 + 0 · x2 = 3
2 · x1 + 3 · x2 = −1
3 · x1 + 1 · x2 = 2
We get x1 = 3, and so x2 = − 73 .
Check if these values of x1 , x2 are consistent with 3rd equation; No.
31 / 56
Solution
A·1 x1 + A·2 x2 = A·3 .
1 · x1 + 0 · x2 = 3
2 · x1 + 3 · x2 = −1
3 · x1 + 1 · x2 = 2
We get x1 = 3, and so x2 = − 73 .
Check if these values of x1 , x2 are consistent with 3rd equation; No.
Thus, all three assets are linearly independent & none is redundant.
31 / 56
Calculating # Linearly Independent Columns

General method for calculating rank (# linearly independent assets) is
Gaussian elimination:
Perform elementary row operations
row multiplication/addition
row switching.
To get row echelon form, i.e.,
All non-zero rows are above rows of all zeroes.
Left element of non-zero row is to right of previous row’s left element.
Rank = # non-zero rows in row echelon form.
Example:
   
1 3 0 1 1 0 1 2
1 1 1 2 → 0 1 0 0, so rank is 3.
1 0 2 3 0 0 1 1
32 / 56
Complete Market
Definition
Complete Market: Market is complete if any payoff can be hedged perfectly.
Mathematically, this is true if # linearly independent assets = # of states.
33 / 56
Complete Market and Arrow-Debreu Securities

Instructive to think of complete markets in terms of Arrow-Debreu securities.
Definition
Arrow-Debreu security : The Arrow-Debreu (elementary) security for state
j, denoted ej , has payoff 1 in state j and 0 in all other states.
     
1 0 0
For example, with 3 states, we have e1 = 0 , e2 = 1 , e3 = 0.
    
0 0 1
Note: Market is complete ⇔ all A-D securities can be replicated.
34 / 56
Hedging in Complete Market, no Redundant Assets
Theorem
Suppose we have m states and a complete market A, with m basis assets.
Then the payoff matrix is invertible and the hedging portfolio for any focus
asset b is given by
x = A−1 b.
35 / 56
Hedging in Incomplete Markets, no Redundant Assets

This corresponds to rank (A) = n < m, i.e., fewer assets than states.
Assume ∃ x s.t.
Ax = b. (1)
Multiply by A0 from the left, to get
A0 Ax = A0 b. (2)
A0 A is square with full rank, so it has an inverse, and so we write

−1 0
x = A0 A A b. (3)
x solves (2) but does it solve (1)?

−1
If yes, x = (A0 A) A0 b is the unique solution.
−1
If no, then we have hedging error = Ax − b = A (A0 A) A0 b − b.
It means that our assumption ∃ x s.t. Ax = b was wrong.
36 / 56
Hedging in Incomplete Markets - Geometry

0
Focus asset b = 1 2 3 .
Basis assets:
0
A·1 = 1 1 0 ,
0
A·2 = 0 1 0 .
Marketed subspace Ax:
The horizontal plane.
Hedging error ε = Ax − b.
Optimality criterion:
0
√ε ⇔
Minimize ε
Minimize ε0 ε, i.e., length of ε.
Point of minimal distance of Ax from b:
ε must be at right angle to all vectors in A: A0 ε = 0.
−1
A0 (Ax − b) = 0 ⇒ x = (A0 A) A0 b.
37 / 56
Hedging in Incomplete Markets, no Redundant Assets

Example:  
1 3
Assume a market with 2 assets has payoff matrix A = 1 2,
  1 1
1.5
and we want to hedge the payoff b = 0.5.
0
Solution
−10
The candidate solution is x̂ = (A0 A)−1 A0 b = 1
12 .
9

0 3 6 −1 14 −6 2
Check that A A = , (A0 A) = 1 0
,Ab= .
6 14 6 −6 3 5.5
We conclude this is nota solution
  
(hence 6 ∃ a solution), since Ax̂ 6= b.
1.42 1.5
In particular, Ax̂ =  0.67  6= 0.5 = b.
−0.08 0
38 / 56
Arbitrage Pricing in One-period Model
39 / 56
Arbitrage
Definition
Arbitrage:
A portfolio x is an arbitrage if:
(i) price is S0 x ≤ 0 and payoff is Ax ≥ 0 with Ax 6= 0, or
(ii) price is S0 x < 0 and payoff is Ax = 0.
Simply put: Arbitrage offers “something” for “nothing”.
Note that:
Arbitrage 6⇒ “riskless” gain, since it might not pay off.
“Arbitrage” is a widely abused term on Wall Street:
M&A arbitrage, liquidation arbitrage, pairs trading: not true arbitrages.
40 / 56
Pairs Trading
41 / 56
Arbitrage - continued
Type II arbitrage:
S0 x < 0, i.e., receive some money today, and
Ax = 0, certain payoff of 0 tomorrow.
Cannot occur if basis assets are linearly independent:
Ax = 0 ⇒ x = 0 ⇒ S0 x = 0.
So must have a redundant asset, in particular, a mispriced one, i.e.,
redundant asset costing more or less than its replicating portfolio.
 
1 3 1.5 2 0
Example: Let A = 1 2 0.5 1 and S = 1 2 1 2 .
1 1 0 0
0
Then x = −1 1 0 −1 has price S0 x = −1 and payoff Ax = 0,

so it is an arbitrage.
Consider asset with payoff A·4 as the redundant asset. Then:
Price of redundant asset = 2 > 1 = price of replicating portfolio.
Complete/incomplete market is irrelevant; didn’t use asset 3 in above.
42 / 56
Arbitrage - continued
Type I arbitrage:
S0 x ≤ 0, pay nothing or receive some money today,
Ax ≥ 0, receive a non-negative amount tomorrow, and
Ax 6= 0, pay-off is strictly positive in at least one state.
 
1 3
1
Example: Let A = 1 2 and S = .
1
1 1
 
2
−1
Then x = has price S0 x = 0 and payoff Ax = 1, so arbitrage.
1
0
Bond pays less than stock in each state.
⇒ Stock is unambiguously more valuable, so should have higher price.
Can have Type I arbitrage in incomplete market, no redundant assets
(so with redundant assets, too).
Complete this market, with any price ⇒ can have Type I arbitrage in
complete market, no redundant assets (so with redundant assets, too).
43 / 56
No-Arbitrage Pricing
No-Arbitrage is used to:
Check that prices of basis assets are “consistent” with equilibrium.

If arbitrage exists, people will exploit it until prices change.
Price focus assets, when prices of basis assets are given:
1 No-Arbitrage Type II is used to price redundant focus assets.

Law of One Price.
2 No-Arbitrage Type I is used to price non-redundant focus assets.

Super-replicating portfolios.
44 / 56
Law of One Price

Definition
Law of One Price:
Prices are linear, i.e., price of payoff Ax is S0 x.
Observations about LOOP:

Doesn’t say that price of portfolio x is S0 x; this is obvious.
Says that payoff Ax, no matter how it is formed, has one price.
n n
xi p (A·i ) = S0 x.
P P
In particular, p (Ax) = p A·i xi =
i=1 i=1
Holds in equilibrium (but doesn’t imply equilibrium).
Proposition
No Arbitrage of type II ⇔ the Law of One Price.
45 / 56
No-Arbitrage (Type II) Pricing - Law One Price - Example

Note that we don’t need a complete market to use Law of One Price.
 
1 3
1
Let payoff matrix A = 1
 2 , with prices S =
 .
2
1 1
 
4
Find no-arbitrage price of security with payoff b = 3.
2
Find portfolio x that replicates b.

1
Since market is incomplete, candidate is x = (A0 A)−1 A0 b = .
1
LOOP says that price of payoff Ax (= b) is S0 x = 3.
46 / 56
State Prices
Denote price of Arrow-Debreu security ej by ψj .
ψj is the price of receiving 1 in state j and 0 in all other states.

Marginal cost of obtaining an additional unit of account in state j.
Vector ψ is called the “state price vector”.
 
1
Example: What is the price of the payoff b = 0?

3
47 / 56
State Prices
Denote price of Arrow-Debreu security ej by ψj .
ψj is the price of receiving 1 in state j and 0 in all other states.

Marginal cost of obtaining an additional unit of account in state j.
Vector ψ is called the “state price vector”.
 
1
Example: What is the price of the payoff b = 0? 
3
   
1 0
Price of 0 is ψ1 , price of 0 is ψ3 , so price of b is ψ1 + 3ψ3 .
0 1
47 / 56
State Prices and Law of One Price

LOOP ⇒ Sj = (A·j )0 ψ, ∀j.
Sj is price of the basis asset with payoff A·j .
Can replicate A·j by buying corresponding amounts of A-D securities.
Price of replicating portfolio is simply sum of prices times units of the
0
A-D securities that replicating portfolio buys, i.e., (A·j ) ψ.
0
Finally, LOOP says a payoff has unique price, hence Sj = (A·j ) ψ.
Stacking these equations in a vector, we have S = A0 ψ.

I.e. ψ is the solution of S = A0 ψ.
ψ might not exist: S and A inconsistent with LOOP (& no arbitrage).
ψ might not be unique: Can (and will) happen in incomplete market.
Can’t replicate A-D securities ⇒ can’t infer prices from S, only bounds.
S = A0 ψ ⇒ LOOP.
0
Consider portfolio x. Its price is S0 x = (A0 ψ) x = ψ 0 Ax.
So if Ax = 0, then S0 x = 0, i.e., 6 ∃ type-II arbitrage, so LOOP holds.
48 / 56
Finding State Prices

 
1 3
3
Example: Let payoff matrix A = 1 2, with prices S = .
6
1 1
Remember, LOOP ⇒ S = A0 ψ.

1 · ψ1 + 1 · ψ2 + 1 · ψ3 = 3
The system S = A0 ψ
can be written as .
3 · ψ1 + 2 · ψ2 + 1 · ψ3 = 6
0
Then the state price vector is ψ = α 3 − 2α α .
49 / 56
Arbitrage Theorem
Arbitrage Theorem
Suppose matrix A ∈ Rm×n represents the pay-off of n securities in m
states and S ∈ Rn is the price of those securities. There is no arbitrage
(either type I or type II) if and only if there is a strictly positive state
price vector
ψ0
consistent with the price of basis assets, i.e.,
S = A0 ψ.
50 / 56
Arbitrage Theorem - Examples

 
1 3
1
Let A = 1 2 and S= .
2
1 1
Decide whether there are any arbitrage opportunities:

0 1 · ψ1 + 1 · ψ2 + 1 · ψ3 = 1
Solve S = A ψ by solving the system: .
3 · ψ1 + 2 · ψ2 + 1 · ψ3 = 2
0
Solution is ψ = α 1 − 2α α .
For α ∈ (0, 0.5), ψ 0, so by AT, ∃ψ 0 ⇒ No Arbitrage.
51 / 56
Arbitrage Theorem - Example

 
  1
2 1 0 3 1 1
 
 1 .
Let payoff matrix A = 1 1 1 2 1 and prices S =  
0 1 2 1 0  2
1
3
If ∃ arbitrage, find arbitrage portfolio x. If not, find ψ 0.
Find linearly independent assets (or rank of A) to check if complete:
r (A) = 3, with A·2 , A·4 , A·5 linearly independent.
−1 0
Candidate for S = A0 ψ is ψ = (AA0 ) AS = 0.67 −0.33 0.67 .

Verify that indeed, candidate ψ satisfies S = A0 ψ. This is unique ψ.

Since 6 ∃ψ 0, Arbitrage Theorem ⇒ there is arbitrage.
   
1 1
Let payoff b = 2. Ignoring redundant assets, x = A−1 1 b =  −1 
0 3
replicates b and has price S0 x = 0, hence it is an arbitrage (of type I).
52 / 56
Arbitrage Pricing Theorem

If there is arbitrage, then 6 ∃ψ 0.
If there is no arbitrage, then:

In a complete market:
There exists a unique ψ 0, and
No-arbitrage price of b is ψ 0 b.
Interpretation – b is combination of elementary securities:
b = b1 e1 + . . . + bn en ,
so price of b equals b1 ψ1 + . . . bn ψn = ψ 0 b.
In an incomplete market:
ψ is no longer unique, and
No-arbitrage price of b ∈ {ψ 0 b : A0 ψ = S, ψ 0},
i.e., take into account all state prices consistent with no arbitrage.
53 / 56
Arbitrage Pricing Theorem - Example

Find no-arbitrage price(s) of the focus asset b:
     
1 3 2 1 1.5
A = 1 2 1, S = 2 , b = 0.5.
1 1 0 1 0
Find linearly independent assets (or rank of A) to check if complete:
r (A) = 2, with A·1 , A·2 linearly independent.

0 1 · ψ1 + 1 · ψ2 + 1 · ψ3 = 1
Again, solve S = A ψ, i.e., .
3 · ψ1 + 2 · ψ2 + 1 · ψ3 = 2
0
Solution is ψ = α 1 − 2α α .
By AT, no arbitrage requires α ∈ (0, 0.5).
No-Arbitrage price of b is ψ 0 b with α ∈ (0,0.5), i.e., price ∈ (0.5, 0.75).
54 / 56
Example
Investment bank believes stock return R takes 3 values:
R1 = 1.3 with probability p1 = 0.3,

R2 = 1.1 with probability p2 = 0.5, and
R3 = 0.8 with probability p3 = 0.2.
There is risk-free account with return rf = 0.05.

Investment bank has sold 1 unit of digital put option with payoff D:
D = 0 for R > 1.05,

D = 1 for R ≤ 1.05
Find all prices of the digital put that prevent arbitrage.

55 / 56
Solution
 
1.05 1.30
Returns matrix of basis assets (bond & stock) is R = 1.05 1.10.
1.05 0.80
56 / 56
Solution
 
1.05 1.30
1.05 0.80
0
The payoff of the digital put option is b = 0 0 1 .
56 / 56
Solution
 
1.05 1.30
1.05 0.80
0
By Arbitrage Pricing Theorem, find ψ to find no-arbitrage prices:

0
ψb:ψ0 .
56 / 56
Solution
 
1.05 1.30
1.05 0.80
0

0
ψb:ψ0 .
Solve 1 = R0 ψ, i.e.,
1.05ψ1 + 1.05ψ2 + 1.05ψ3 = 1
1.30ψ1 + 1.10ψ2 + 0.80ψ3 = 1.
56 / 56
Solution
 
1.05 1.30
1.05 0.80
0

0
ψb:ψ0 .
1.05ψ1 + 1.05ψ2 + 1.05ψ3 = 1
1.30ψ1 + 1.10ψ2 + 0.80ψ3 = 1.
0.25 1.25
0
Find ψ = − 1.05 + 1.5ψ3 1.05
− 2.5ψ3 ψ3 , with ψ3 a free parameter.
56 / 56
Solution
 
1.05 1.30
1.05 0.80
0

0
ψb:ψ0 .
1.05ψ1 + 1.05ψ2 + 1.05ψ3 = 1
1.30ψ1 + 1.10ψ2 + 0.80ψ3 = 1.
0.25 1.25
0
Find ψ = − 1.05 + 1.5ψ3 1.05
− 2.5ψ3 ψ3 , with ψ3 a free parameter.
In this case, ψ 0 b = ψ3 , so the set of no-arbitrage prices of option is

1 1
, .
6.3 2.1
56 / 56

Static Arbitrage

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Static Arbitrage

Uploaded by

Copyright:

Available Formats

University of Geneva

One-Period Model of Financial Markets

The model: One period, finite number of states

Security: An investment instrument issued by an organization.

Debt: Entitles holder to payment of principal and interest.

Equity: Entitles holder to a share (fraction) of the company’s

Note: In bankruptcy, debt-holders take control.

Finance Terminology (continued)

Payoff = amount of money one receives by owning the security

Return = Payoff / Price paid

Risk-free asset: Whose future payoff is known with certainty

Portfolio: Collection of investments held by institution or individual

Finance Terminology (continued)

Finance Terminology (continued)

Finite-state, One-period model

Finite number of states of the world

Price of asset today is known, but payoff tomorrow is uncertain.

Finite-state, One-period model

So why study it?

Introductory Example - Scenario

Using Matrices to Represent Model

Use vectors/matrices to compactly represent payoffs, prices, etc.

Use matrix algebra to simplify and speed up calculations.

Use matrix theory to relate finance and mathematical concepts

⇒ gain valuable intuition

Useful to represent payoff of asset i as m×1 vector, ai ; m is # of states

Example – Buy two options #1, issue/sell one option #2:

Matrix as a collection of securities/vectors

Note that in matrix A:

Reminder - Matrix Multiplication

Matrix Multiplication and Portfolio Payoffs

Matrix Multiplication and Portfolio Prices

Model Representation - Exercise

Find the following:

2. What is the payoff of holding 1 unit of each asset in the market?

Model Representation - Exercise - Solution

Asset payoffs Bond 1 1 1

Model Representation - Exercise - Solution

Asset payoffs Bond 1 1 1

2. What is the payoff of holding 1 unit of each asset in the market?

Model Representation - Exercise - Solution

Asset payoffs Bond 1 1 1

2. What is the payoff of holding 1 unit of each asset in the market?

Model Representation - Exercise - Solution

Asset payoffs Bond 1 1 1

2. What is the payoff of holding 1 unit of each asset in the market?

The General Problem

We want to find the n × 1 portfolio vector, x, such that Ax = b.

The interpretation of b and x depends on the problem we consider:

A11 x1 + A12 x2 + . . . + A1n xn = b1

Reminder - Calculating Inverse of 2 × 2 Matrix

where |A| = a11 a22 − a21 a12 .

Reminder - Calculating Inverse of 3 × 3 Matrix

Calculating Inverse of 3 × 3 Matrix - Example

Reminder - Calculating Inverse of n × n Matrix

doing elementary row operations on the augmented matrix:

The Hedging Problem - Example

The Hedging Problem - Examples of Complications

The Hedging Problem - Examples of Complications

Securities A·1 , . . . , A·n are linearly independent if all non-zero

A·1 x1 + A·2 x2 + . . . + A·n xn = 0.

Example - Linearly Independent Assets

How many linearly independent assets are there?