The one-period model State prices and arbitrage

Arbitrage Pricing with Multiple States

Pricing derivatives

Henrik Olejasz Larsen

University of Copenhagen, 2012

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

A two period economy, t = 0, 1 At t = 1 the true state of the economy is revealed as one of a nite set of S possible states = {1 , . . . , S }

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

N securities traded at t = 0 Securities characterized by their pay off or dividend at t = 1 dependent on the revealed state of the economy d11 . . . d1S . . .. . D= . . . . dN 1 . . . dNS The securities can be traded at t = 0 at prices q RN

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

"There is no ignorance, there is knowledge"

A portfolio of the N securities is represented by RN A positive element in is called a long position in the relevant security, a negative is called a short position The portfolio has the price q at t = 0 and the dividend at t = 1 of D RS Investors may disagree on the probabilities of the states in , but we assume that all on agree on D and that every state is possible

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Denition (Arbitrage opportunity) An arbitrage opportunity (or just an arbitrage) is a portfolio RN such that q 0 and D > 0 or q < 0 and D 0 Remark The denition is equivalent to dening an arbitrage opportunity as a portfolio RN with payments m = (q , D ) R RS that has m > 0

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Denition (Arbitrage free) The pair (q, D) is arbitrage free if there is no arbitrage opportunity Remark The pair (q, D) is arbitrage free if and only if M K = 0, where K is the positive cone R+ RS + in the vector space S L = R R and M is the marketable space m R RS |m = (q , D ), RN

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Denition (State prices) A state price vector is a strictly positive vector RS such that q = D Theorem (Fundamental theorem of arbitrage pricing) The pair (q, D) is arbitrage free if and only if there is a state price vector

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Lemma (Separating Hyperplane Theorem) Suppose two convex sets A, B RN are disjoint. Then there is a linear functional F on RN and a value c R such that F (x) c for all x A and F (x) c for all x B Proof. See ?, Theorem M.G.2. A linear functional is just a linear map on a vector space to the scalars (here a dot product with a constant vector)

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

For general illustration - this is not our K or M!

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Proof (if)

If we have strictly positive state prices then non arbitrage follows directly

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Proof (only if)

Let L, K , M be as in the remark above. By the lemma since K is convex there is a hyperplane U in L such that M U and U K = 0 The hyperplane separates such that there is a linear functional F : L R with kernel N (F ) = U such that F (x) > 0 x K \ {0}. Write an element (v, c) L with v R and c RS as v(1, 0) + S j=1 cj (0, ej ) where (1, 0), (0, e1 ), . . . , (0, eS ) is the canonical basis of L. Let = F (1, 0) and = F (0, e1 ), . . . , F (0, eS ) . Since the basis vectors are all in K , they are strictly positive. Now F (v, c) = vF (1, 0) + cF (0, e) = v + c
Henrik Olejasz Larsen Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Since M is in the kernel of F v + c = 0 for (v, c) M . Thus q = D . Simplify by dividing by and get q = D , where = /. To interpret the , note that by taking a portfolio i = (0, . . . , 1, . . . , 0) with just one security i we get qi = S s dis s Thus are state prices as in the theorem.

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

With no bid-ask spread the situation looks like K ) (1, M

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

With a bid-ask spread the state prices are not uniquely given

) (1, M

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Back to the Binomial

Let S = 2 and N = 3 Let securities be such that such that q = (1, S0 , f0 ) and D= er Su fu e r S d fd

With arbitrage free prices there exists state prices (1 , 2 ) such that q=D 1 2

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Back to the Binomial 2

Suppose that f0 is unknown If Su = Sd the matrix D12 = is invertible We nd f0 = fu fd
1 D 12

er Su er Sd

1 S0

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Outline

The one-period model States of the world Securities Portfolios Arbitrage State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Denition (Redundant securities) A security that has payoffs that can be replicated by a portfolio of other securities (called a replicating portfolio) are said to be redundant. Remark (Pricing of redundant securities) In an arbitrage equilibrium a redundant security must have the same price as the replicating portfolio

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Denition (Complete markets) If payoff that can be achieved by portfolios x RS | RN has the full dimension S the security markets are complete

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Arrow-securities

Denition (Arrow-securities) A security that has a pay-off of 1 in a state j is called the j-Arrow security Remark (State prices as prices of Arrow securities) Suppose we have an arbitrage equilibrium where are state prices. Then a price of a j-Arrow security of j will be arbitrage free (i.e. if we add this security to the set of securities and give it this price we will still have an arbitrage equilibrium)

Henrik Olejasz Larsen

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Note that arbitrage free prices are necessary for a solution to the investors portfolio optimization problem, thus for a general equilibrium

Henrik Olejasz Larsen

Arbitrage Pricing

Appendix References

Bibliography

Andreu Mas-Colell, Michael D. Whinston, and Jerry R. Green. Microeconomic Theory. Oxford University Press, 1995.

Henrik Olejasz Larsen

Arbitrage Pricing