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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

States Pricing derivatives Henrik Olejasz Larsen University of Copenhagen, 2012 Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

1 The one-period model States of the world Securities Portfolios Arbitrage

2 State prices and arbitrage The fundamental theorem of arbitrage pricing An example

Henrik Olejasz Larsen

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

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 finite set of S possible states Ω = {ω 1 ,

, ω S }

Henrik Olejasz Larsen

as one of a finite set of S possible states Ω = { ω 1 ,

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

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

D =

d 11

.

.

.

d N1

.

.

.

.

.

.

.

.

.

d 1S

.

d NS

The securities can be traded at t = 0 at prices q R N

Henrik Olejasz Larsen

    The securities can be traded at t = 0 at prices q

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

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 θ R N

A positive element in θ is called a long position in the

relevant security, a negative is called a short position

The portfolio θ has the price q θ at t = 0

and the dividend at t = 1 of D θ R S

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

in Ω , but we assume that all on agree on D and that every state

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Definition (Arbitrage opportunity)

An arbitrage opportunity (or just an arbitrage) is a portfolio θ R N such that

q θ 0 and D θ > 0 or q θ < 0 and D θ 0

D θ > 0 or q θ < 0 and D θ ≥ 0 Remark The

Remark The definition is equivalent to defining an arbitrage opportunity as a portfolio θ R N with payments m = (q θ, D θ) R × R S that has m > 0

m = ( − q θ, D θ ) ∈ R × R S that has

Henrik Olejasz Larsen

m = ( − q θ, D θ ) ∈ R × R S that has

Arbitrage Pricing

The one-period model State prices and arbitrage

States of the world Securities Portfolios Arbitrage

Definition (Arbitrage free)

The pair (q, D) is arbitrage free if there is no arbitrage opportunity

D ) is arbitrage free if there is no arbitrage opportunity Remark The pair ( q

Remark The pair (q, D) is arbitrage free if and only if M K = 0, where K is the positive cone R + × R + S in the vector space L = R × R S and M is the marketable space m R × R S |m = (q θ, D θ), θ R N

space m ∈ R × R S | m = ( − q θ, D θ

Henrik Olejasz Larsen

space m ∈ R × R S | m = ( − q θ, D θ

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Definition (State prices)

A state price vector is a strictly positive vector ψ R S such that q = Dψ

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

pair ( q , D ) is arbitrage free if and only if there is a

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 R N are disjoint. Then there is a linear functional F on R N and a value c R such that F(x) c for all x A and F(x) c for all x B

for all x ∈ A and F ( x ) ≤ c for all x ∈

Proof. See ?, Theorem M.G.2.

) ≤ c for all x ∈ B Proof. See ? , Theorem M.G.2. A linear

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

map on a vector space to the scalars (here a dot product with a constant vector)

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! K M Henrik Olejasz
For general illustration - this is not our K or M!
K
M
Henrik Olejasz Larsen
Arbitrage Pricing

Proof (if)

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

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

Henrik Olejasz Larsen

If we have strictly positive state prices then non arbitrage follows directly Henrik Olejasz Larsen Arbitrage

Arbitrage Pricing

Proof (only if)

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

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 R S as

v(1, 0) + j=1 c j (0, e j ) where (1, 0), (0, e 1 ), canonical basis of L. Let α = F(1, 0) and

φ = F(0, e 1 ),

in K, they are strictly positive.

Now F(v, c) = vF(1, 0) + cF(0, e) = vα + cφ

S

, (0, e S ) is the

, F(0, e S ) . Since the basis vectors are all

Henrik Olejasz Larsen

0 , e S ) is the , F ( 0 , e S ) .

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 vα + cφ = 0 for (v, c) M. Thus αq θ = D θφ. Simplify by dividing by α and get q θ = D θψ, where ψ = φ/α.

To interpret the ψ, note that by taking a portfolio

θ i =

q i =

Thus ψ are state prices as in the theorem.

(0,

S

s

, 1,

d is ψ s

, 0) with just one security i we get

Henrik Olejasz Larsen

theorem. ( 0 , S s , 1 , d is ψ s , 0 )

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, ψ) M Henrik Olejasz
With no bid-ask spread the situation looks like
K
¯
(1, ψ)
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, ψ) M Henrik Olejasz Larsen
¯
(1, ψ)
M
Henrik Olejasz Larsen
With a bid-ask spread the state prices are not uniquely given ¯ (1, ψ) M Henrik

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

The one-period model State prices and arbitrage

Back to the Binomial

The fundamental theorem of arbitrage pricing An example

Let S = 2 and N = 3

Let securities be such that such that q = (1, S 0 , f 0 ) and

D =

e

e

r

r

S

S

u

d

f u f d

With arbitrage free prices there exists state prices (φ 1 , φ 2 ) such that

q = D φ φ 2

1

Henrik Olejasz Larsen

Arbitrage Pricing

exists state prices ( φ 1 , φ 2 ) such that q = D φ

The one-period model State prices and arbitrage

Back to the Binomial 2

The fundamental theorem of arbitrage pricing An example

Suppose that f 0 is unknown

If S u = S d the matrix

D 12 = e e r

r

is invertible

We find

u d

S

S

f 0 = f f d u D 1

12

S 1 0
S
1
0

Henrik Olejasz Larsen

Arbitrage Pricing

Outline

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

1

2

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

prices and arbitrage The fundamental theorem of arbitrage pricing An example Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Definition (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

a redundant security must have the same price as the replicating portfolio Henrik Olejasz Larsen Arbitrage

Arbitrage Pricing

The one-period model State prices and arbitrage

The fundamental theorem of arbitrage pricing An example

Definition (Complete markets)

If payoff that can be achieved by portfolios x R S |θ R N has the full dimension S the security markets are complete

Henrik Olejasz Larsen

| θ ∈ R N has the full dimension S the security markets are complete Henrik

Arbitrage Pricing

The one-period model State prices and arbitrage

Arrow-securities

The fundamental theorem of arbitrage pricing An example

Definition (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 ψ are state prices. Then a price of a j-Arrow security of ψ 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

of securities and give it this price we will still have an arbitrage equilibrium) Henrik Olejasz

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

to the investors portfolio optimization problem, thus for a general equilibrium Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing

Bibliography

Appendix

References

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

Henrik Olejasz Larsen

and Jerry R. Green. Microeconomic Theory . Oxford University Press, 1995. Henrik Olejasz Larsen Arbitrage Pricing

Arbitrage Pricing