In this module, we'll introduce the

concept of no-arbitrage and work through a very simple example of the applicatio
n
of the no-arbitrage principle to pricing. Consider a contract that pays ck dolla
rs
at time t equal to k, where k takes values one, two, three
up to T. And let's say that one has to pay a price
p at time t equal to zero in order to receive this contract,
in order to get this cash flow. So the story is, here is time t equal to
zero, where you pay a price p. Here is time t is equal to one, and all
the way up to time t equal to capital T. And you, you get cash flows c one, c tw
o,
and so on, up to c capital T. And the goal of this module, is to
introduce ideas of no-arbitrage that allow us to, fix this
price p. It'll turn out that in certain
circumstances we will be able to fix this price exactly. And in certain other ci
rcumstances, we can
only be able to bound the price. We can tell you the price cannot be larger
than a certain quantity, and cannot be smaller
than a certain quantity. There are two ideas of arbitrage that are used in finan
cial
engineering. One idea is called weak no-arbitrage, and the second idea is called
strong
no-arbitrage. Both of these ideas essentially eliminate
the possibility of a free lunch. Let's first consider weak no-arbitrage. What th
is condition says is, suppose there
is a contract such that the cash flows
associated with this contract are non negative for all times K greater
than equal to one. C1, C2, C3 and so on up through C capital
T are all greater than equal to zero. If there is such a contract then the price
for this contract must be greater than
equal to zero. The stronger arbitrage condition says that
suppose there is a contract for which the cash flows are non negative for all ti
mes
in the future, and there exists some time, cl in the future, such that the cash
flow is strictly positive. Then the price for such a contract must be
strictly positive. Both of these conditions are motivated by
the fact that in a market if there are contracts
for which you get something for nothing, then just
by supply and demand that price, that contract will
be priced to a point where you had to pay a fair price. Let's walk through the r
ationale for the
weak no-arbitrage condition. Suppose there exists a contract for which
CK is greater than equal to zero. That means you get non negative cash flows
for all times in the future, but the price for such a
contract is less than zero. So, weak no-arbitrage says that price must
be greater than equal to zero. Here, I'm assuming that the price is less than ze
ro, and let's see what happens. Since CK is greater than equal to zero,
you do not owe anything in the future. And the buyer of such a contract receives
minus P, because P is less than zero, which means you have to pay a
negative amount or receive it. Which is the same thing as saying you
receive a positive amount at time T equal to zero, the buyer
never loses anything. And at the same time, gets money at time t
equal to zero. This is a free lunch, weak no-arbitrage
condition says this cannot happen. Why cannot it not, what, why can't this happe
n? This cannot happen because if there is
such a contract such that p is less than zero, then the seller of such a
contract will start increasing the price. It's a bad deal for the seller. The se
ller will keep increasing the price,
but for any price p less than zero this is a very good deal for the buyer, so th

e
buyers are still going to be there. And this price, the seller will keep
increasing the price until p hits equal to zero.
At least she might be able to increase the price to
be something greater than zero, but the weak
no-arbitrage condition does and, doesn't allow us to figure out how exactly
this price is going to work once the price becomes
greater than zero. We can only say using a weak no-arbitrage
condition, that the price will be increased until p becomes
greater than equal to zero. You can make the same argument from the
buyer's perspective, since it is a good deal for any price less
than zero, the buyers will be willing to pay a higher
price in order to compete. They will compete with each other until
the speed less than zero cannot be sustained in the
market. Recall, in the other module, I talked
about the fact that how prices get set by supply and
demand. You again see here that the rationale for weak no-arbitrage is built on
supply and
demand. We are building it on the fact that there are many buyers, many
s-, sellers. We are also using the fact that the
information about the details of the contract are publicly available, are unifor
mly available to buyers and
sellers. This is going to be important and we'll
emphasize this again on the next slide. Here, I'm going to work through the rati
onale for a strong no-arbitrage
condition. Suppose p is less than equal to zero. Strong no-arbitrage conditions
says that p
must be strictly greater than zero for a contract for which
the future cash flows are greater than equal to zero,
and that exists sometime where the cash flow
is strictly positive. Since CL is greater than zero for some L greater than equa
l to one, even if p is
equal to zero, this is a free lunch. It's a free lunch as long as p is less
than equal to zero. Again using the same arguments that we
used before, the seller of such a contract will have an incentive
to increase the price. The buyers will still be around, because it's still a goo
d deal at something
positive. We cannot guarantee what the precise value
of the price is going to be. But for some price strictly positive it'll still re
main
a good deal because there exists a cash flow cl which is strictly positive
for some time, L, in the future. And again, buyers and sellers will compete in
order to set the price p. The implicit assumptions that are
underlying the no-arbitrage conditions are the
markets are liquid, which means there are
sufficient numbers of buyers and sellers. If the markets are il-liquid, then noarbitrage condition is not valid, and
the bounds that we generate using the no-arbitrage argument will no longer be
valid. We also assume that price information is
available to all buyers and sellers. The price information here basically
means, what are the cash flows? If there are buyers and sellers which are
ignorant about the cash flows, then the price formation
process will not happen. We also assume that the competition in
supply and demand will correct any deviation from the
no-arbitrage prices. And this again presupposes that there is a
market, these markets are liquid. The price information goes to every buyer
and every seller, so that they can decide how
to set the price efficiently. The rest of this module I'll just walk you
though a very simple example in how to use no-arbitrage condition to price a ver
y simple fixed income

instrument. In the later modules we will go over more

complicated examples where you use no-arbitrage condition to set prices for
more complex derivatives. So consider a very simple bond. What this bond gives y
ou is 8 dollars in
one year, and we want to set the price for
this bond. Suppose in the market, one is able to
borrow and lend unlimited amounts at an interest rate
r per year. So, the bond pays $8 in one year. We can borrow and lend unlimited a
mounts
at the interest rate of r per year. And we want to figure out, what is a fair pr
ice, or an arbitrage
free price for a contract that pays $8 in one
year. We'll do it by constructing two different
portfolios. So let's construct the following
portfolio. You buy the contract at price p, and you
borrow a divided one plus r dollars at an interest
rate of r. Consider the cash flows associated with
this portfolio. In the future, in one year, the contract
will pay A dollars and you've borrowed A
divided by one plus r at the interest rate of r, so you have
to pay A dollars. These two cancel each other. So the cash flow in one year is A
minus A
equal to zero. So c1 is equal to zero. And what is the price of this portfolio?
The price of this portfolio is p, the amount that you had to pay to
get the contract, minus A divided by one plus r, because this was the cash flow
that you received at time T equal to zero. So the net price that you paid for th
e
portfolio is p minus A over one plus r. Now, let's use the weak no-arbitrage
condition. The weak no-arbitrage condition says that
if the cash flows in the future, and in this
particular case there's only one time in which there is a cash
flow in the future in one year. If the cash flows in the future are
greater than equal to zero, then the price must be greater
than equal to zero. C1 greater than equal to zero implies that
the price of the portfolio Z must be greater than
equal to zero. Price Z is equal to P minus A divided by
one plus R. This must be greater than equal to zero,
which means that P must be greater than equal to A divided by
one plus R. So we now get a lower bound for the price. No-arbitrage weak no-arbi
trage condition
gives me a lower bound on the price. And we got this lower bound by
constructing an appropriate portfolio. Now, in the next slide, we'll get an uppe
r bound for the price by constructing a
different portfolio. So construct a portfolio, we sell the
contract at price B, and lend A divided by one plus r at the
interest rate r. Now what happens? The cash flow is again zero in the future,
because you've lent an amount A divided by one plus r at
interest rate r. So in one year this becomes, this returns
your value A. Since you have sold the contract, you are
now responsible to pay A dollars to the buyer of the contract in
one year. These two cash flows cancel each other,
and therefore C1 again is greater than equal
to zero. In fact C1 is equal to zero, which is the
same thing as greater than equal to zero. It satisfies the condition that greate
r
than, C1 is greater than equal to zero. What about the price of this portfolio?
The price of the portfolio is how much did you have to pay, in order construct t
his
portfolio. . Since you sold the contracted price p you
receive that amount, so that's minus p, because you had to lend A divided by one

plus r, the interest rate r. This is the out flow, so A divided by one plus r is
the total amount that you had to
pay. The difference between these two, A
divided by one plus r minus p, tells you the price of the
portfolio. A weak no-arbitrage condition tells me
that since C1 is greater than equal to zero,
the price that I paid for this contract must also be
greater than equal to zero. So, z is equal to A divided by one plus r
minus p. This must be greater than equal to zero,
which means that A divided by one plus r must be greater than
equal to p. If you combine this upper bound with the
lower bound, that we constructed in the slide just
before, you get that p must be exactly equal to one plus r.
Could this be a surprise? Not at all. All we are doing is constructing the net p
resent value calculation using a
no-arbitrage condition. The advantage of doing this net present
value calculation using the no-arbitrage
condition is that it clearly shows what are the assumptions that are
needed in order for the net present value to
exist. It relied heavily on the ability to borrow
and lend at the interest rate r, an unlimited
amount. If we are a, if these assumptions are not
true, then the net present value is not the
correct price. And we would have to use some other
techniques to figure out what the correct price would
be. And no-arbitrage conditions would still be
valid, except that we will have to use them with different
portfolios perhaps. So what happens if the borrowing and then
the lending rates are different? I can't use net present value, but I can
use no-arbitrage. What if the borrowing and lending markets
are elastic, which means that if you want to borrow or
lend. The interest rate that you're going to be
charged depends on the amount that you're
borrowing or lending. What happens in that case? Again the net present value cal
culation is not valid, but we can construct
no-arbitrage conditions which would give us, if not the exact
price, at least bounds on what such a contract
can cost.