Tópicos de Economı́a Financiera – EAE-378D

Evaluación por No-Arbitraje

Jaime Casassus

Instituto de Economı́a
Pontificia Universidad Católica de Chile

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Tabla de Contenidos

1 Derivatives

2 Pricing Derivatives

3 Arbitrage Pricing

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What are derivatives?
• The first part of the course develops tools to price and hedge
derivative securities.
• A derivative security is a financial instrument whose payoff is
contingent on (i.e., ‘derives’ from) the value of an underlying asset.
• Examples:
◦ Commodities - Crude Oil Futures Contracts (NYMEX); Natural Gas
(NYMEX); Gold (NYMEX); Pork Belly (CME)
◦ Stocks - Dow Jones Industrial Average Index Options (CBOE); S&P
500 Index Futures (CME)
◦ Bonds - Long Term Interest Rate Options (CBOE)
◦ Foreign Exchange - USD / Euro FX options (CME)
◦ Weather, e.g., the average January temperature in Florida (Note: the
underlying is not really an asset - correlated with Orange juice Futures,
however).
◦ Another Derivative: Euro Dollar Interest Rate Futures Options (CME)
◦ Credit Risk: Credit Default Swaps.
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The Building Blocks: Forward Contracts

• A forward contract is a commitment to buy or sell an asset at a
certain time in the future for a certain price.
◦ The party that agrees to sell has a short position.
◦ The party that agrees to buy has a long position.
• Typically,
◦ Forward contracts are Over the Counter (OTC) agreements.
◦ No payments are made by either counterparty when entering a forward
contract.
◦ Forward contracts are settled at maturity.
◦ Forward prices differ across maturity.
◦ Note: It is important to distinguish the value of the Forward Contract
from the Forward (delivery) price:
◦ The value of the forward contract is zero at the initial date.
◦ The value of the forward contract is equal to the discounted payoff at
the maturity of the contract.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 4 / 25

The Building Blocks: Forward Contracts (cont.)
• An Example of a Forward Contract
◦ Consider a gold forward contract entered into on September 1 for
delivery of 100 troy oz. of gold in exchange for a forward price of $300
per troy oz., with the delivery and exchange to occur at the contract’s
December 1 maturity.
◦ If at maturity, gold is selling for $330, the long’s profit under the
contract will be $3, 000 = (330 − 300) × 100. The short will lose
$3, 000.
◦ If at maturity, gold is selling for $293 per troy oz., the long will lose
$700 = (293 − 300) × 100. The short will profit by $700.
• The Payoff of a long Forward at maturity T is:
VT = ST − K
• where
◦ St : spot price of the underlying at time t
◦ K : is the forward delivery price agreed upon when the contract was
initiated.
• How was the forward price of $300 determined?
Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 5 / 25

The Building Blocks: Futures Contracts

• A futures contract is a forward contract whose gains and losses are
marked to market daily.
◦ Daily gains accrued from the futures position may be withdrawn.
◦ Daily losses accrued from the futures position must be paid (through
margin calls).

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The Building Blocks: Futures Contracts (cont.)
• An Example of a Futures Contract
◦ Suppose you want to commit to buy wheat in two days. You can go
long a forward or a futures contract.
◦ Typical cash-flows sequence associated with either is:
Time 0 1 2
Spot price 5.60 5.45 5.55
Forward price (T = 2) 5.50 5.47 5.55
Futures price (T = 2) 5.50 5.47 5.55
Cash-fl. from Forward 0 0 5.55-5.50=0.05
Cash-fl. from Futures 0 5.47-5.50=-0.03 5.55-5.47=0.08
◦ Note that all prices converge to the same value at maturity.
◦ Total gains from the forward position equal total gains from the futures
position (0.05 = 0.08 − 0.03).

• Should Futures prices be equal to Forward Prices?

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 7 / 25

The Building Blocks: Swaps

• A Swap contract is a commitment to swap a series of future cash
flows at specific dates.
◦ Swap contracts are Over the Counter (OTC) agreements.

◦ A swap can typically be seen as a portfolio of forward contracts.

◦ Similar to forward contracts, no payments are made by either

counterparty when entering a swap.

◦ An interest rate swap is a commitment to exchange a sequence of

floating rate payments (for example indexed to 6-month LIBOR)
against fixed rate payments. The fixed rate is chosen so that the swap
has zero value at the initial date.

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The Building Blocks: Options
• A call option gives the holder the right to buy an underlying asset for
a certain price at a specific date.
• A put option gives the holder the right to sell an underlying asset for
a certain price at a specific date.
• European options can only be exercised on their expiration date.
• American options can be exercised at anytime before expiration.
• Note:
◦ The buyer of an option owns a right.
◦ The seller of an option has a commitment.
◦ Options are thus asymmetric,
◦ they have a price (the premium).
◦ Typically, American options are worth more than European options.
• Calls and Puts are plain-vanilla options.
• There exists many Exotic Options (asian, barrier, chooser, rainbow,
quanto, digital, cliquet, ladder, shout, reload, lookback. . . )
• And many embedded options (callable, convertible bonds, mortgage
prepayment option, default. . . )
Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 9 / 25

The Building Blocks: Options (cont.)

• Example of Option Contract
◦ A European call option on GM stock with a December 1 maturity and
an exercise price of $75 gives the long the right to demand from the
short delivery of one share of GM on December 1 in return for payment
of the exercise price $75. Suppose the contract is entered into on
September 1 at a price of $6 per contract.
◦ On December 1, if GM stock is selling above $75, the long receives the
stock and pays $75 per share. The short delivers the stock and receives
$75 per share.
◦ On December 1, if GM stock is selling below $75, the owner of the call
option does not exercise.
• How was the call price of $6 determined?
• The Payoff of a long Call at maturity T is: CT = max[ST − K , 0]
• The Payoff of a long Put at maturity T is: PT = max[K − ST , 0]
• where
◦ St : spot price of the underlying at time t
◦ K : is the strike price agreed upon when the contract was initiated.
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Tabla de Contenidos

1 Derivatives

2 Pricing Derivatives

3 Arbitrage Pricing

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 11 / 25

Approaches to Pricing Derivatives?

• There are two complementary approaches to valuation:
• Equilibrium Pricing

• (No-)Arbitrage Pricing

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Equilibrium Pricing (Supply = Demand)
• Make several assumptions about the characteristics of an economy.
◦ What is the role of consumers and how do they act?
◦ What is the role of firms and how do they act?
◦ How are resources allocated across all members of the economy?
◦ How do firms and consumers trade in good and financial markets?
• Consumers maximize utility to determine optimal consumption, labor,
and portfolio allocations. Firms maximize profits to determine
optimal production plans.
• Prices of all assets are determined by equating demand to supply.
• The CAPM is an example of equilibrium pricing model. (Recall the
assumptions on agents preferences and on the structure of the
economy?).
⇒ A difficult task with many assumptions....

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(No) Arbitrage Pricing

• An arbitrage opportunity is a portfolio that
◦ costs nothing (or has a negative price) today,
◦ never pays a negative cash flow in the future,
◦ and pays a strictly positive cash flow in the future with a positive
probability.
⇒ An arbitrage is free money, a free lunch. (Arbitrage opportunities are
riskless.)
• No arbitrage pricing is based on the weak assumption that agents prefer
more to less.
• With no reference to demand functions, allocations or specific preferences,
but simply if agents prefer more to less, then in equilibrium there can be no
arbitrage opportunity.
• Ruling out arbitrage opportunities implies restrictions on the relative price of
assets, which can be exploited to price derivative securities relative to the
price of the underlying.
⇒ This is the essence of (no-)arbitrage pricing (i.e., pricing by assuming that
there are no arbitrage opportunities).
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Example of Arbitrage Opportunities
• Suppose individual pencils are traded for a price of p1 and packs of 12
pencils are traded for a price p12 .

• Under arbitrage pricing theory, as long as repackaging is neither costly

or illegal, p12 = 12 p1 . Otherwise, someone could earn arbitrage
profits.

• If p12 < 12 p1 , someone could buy a pack of twelve pencils and sell
them individually, earning 12 p1 − p12 > 0 at no cost.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 15 / 25

Example of Arbitrage Opportunities - Arbitrage or Not?

• Consider the following investment opportunity:
Payoff in 1 Year
Cost Today With prob. 0.999 With prob. 0.001
0 $100 -$1

• Arbitrage Opportunity?

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 16 / 25

The Law of One Price

In a frictionless market, the absence of ar-

bitrage opportunities implies that two port-
folios with the same set of cash flows must
have the same price.

• The Law of One Price is a fundamental implication of the absence of

arbitrage opportunities.

• All derivative pricing is based on the LOP.

• The general approach to derivative pricing is:
◦ Determine the cash flows of the derivative security.
◦ Find a portfolio which comprises only traded assets with the same set
of cash flows.
⇒ By the LOP the price of the derivative must be equal to the value of
this replicating portfolio.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 17 / 25

Tabla de Contenidos

1 Derivatives

2 Pricing Derivatives

3 Arbitrage Pricing

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 18 / 25

Static versus Dynamic Arbitrage Pricing
• We may distinguish two types of arbitrage-pricing:
• Static arbitrage pricing:
◦ The replicating portfolio strategy is static (one-shot).
◦ The arbitrage relation is model independent.
◦ Put-Call Parity is an example of static arbitrage relation.
• Dynamic arbitrage pricing:
◦ The replicating strategy is dynamic (the portfolio is rebalanced at
various dates).
◦ The arbitrage relation is, in general, model-dependent (assumptions are
made about the underlying price dynamics).
◦ The Black & Scholes formula is an example of a dynamic arbitrage
relation.

⇒ When a dynamic arbitrage is found in the data, one should always

make sure the assumptions underlying the model are reasonable
before trading on it!
Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 19 / 25

Example 1: No Arbitrage Pricing and Bond Prices

• AOA implies strong relation between prices of coupon bonds and
prices of zero-coupon bonds
• Suppose you observe the following bond prices:
Prices Year 1 Year 2 YTM
P =? 100 1100 ?
Z1 = 94.34 100 - 6%
Z2 = 89.00 - 100 6%
• What price P is compatible with AOA?
• Note: P’s Cash flows are identical to those of a portfolio of 1
zero-coupon bond Z1 and 11 Z2 .
• Notice that in AOA P’s YTM is equal to 6% (why)?
• Conclusion: When the term structure of interest rates is flat, AOA
implies that all bonds have same YTM.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 20 / 25

Example 2
• Suppose now:
Prices Year 1 Year 2 YTM
P1 = 1418.44 300 1300 6.89%
P2 = 1055.08 100 1100 6.96%
Z1 = 94.34 100 - 6%
Z2 = 87.34 - 100 7%

• Note that AAO still implies (Why?):

• P1 = 3Z1 + 13Z2 = 1418.44

• P2 = Z1 + 11Z2 = 1055.08.

• Conclusion: When the term structure of interest rates is NOT flat,

bonds need not necessarily have the same YTM, even if the market is
arbitrage-free.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 21 / 25

Example 3
• Consider the following two risk-free bonds.
Bond Price CF Year 1 CF Year 2
A 20 12 15
B 59 36 45

• Is there an arbitrage opportunity?

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 22 / 25

Put-Call Parity for Non-Dividend Paying Underlying
• Assume the expiration date T and strike price K is fixed across all
options. Assume the underlying security pays no dividends.
• By no-arbitrage, the put-call parity relationship is:
K
ct − pt = St − (1+R)(T −t)

• Two possible interpretations:

◦ The value of a position long call-short put (ct − pt ) is equal to a long
K
forward position (St − (1+R)(T −t) ).

K
◦ The value of cash plus upside potential ( (1+R)T + ct ) equals long

position in the underlying plus downside protection (St + pt ).

• Note:
◦ Put-call parity gives the formula for the synthetic creation of one
security using the other three.
◦ Put-call parity addresses the relative pricing of actual and synthetic
options.
Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 23 / 25

Put-Call Parity for Non-Dividend Paying Underlying

K
• Suppose that: ct + (1+R)(T −t)
− pt − St > 0.

• Show that you can combine both options, the underlying and
borrowing/lending to obtain arbitrage profits.
Payoff at T
Position Today (t) ST < K ST ≥ K

Total
K
• Suppose now that −ct − (1+R)(T −t)
+ pt + St > 0.

Casassus (UC) EAE-378D - Economı́a Financiera 6-Aug-10 24 / 25

Example of Dynamic Arbitrage Pricing
• Suppose that for $1 you can participate in a coin flip lottery (L1 ) which pays
$3 if heads show and nothing else. You may purchase as many of these as
you want and at any time of your choosing. At the same time you are
offered $9 to participate in another lottery (L3 ) where the same coin will be
flipped three times and you will loose $27 if heads show at least twice.

• Assuming it is the same coin that determines the outcome of both lotteries,
show that there is an arbitrage opportunity for you to make $2 if you accept
the second lottery and play wisely the first. (assume that the coin are
flipped sufficiently rapidly that we can neglect the time value of money
between two coin flips!)

• Is it still an arbitrage opportunity if two different coins are flipped for both
types of lotteries?

• Hint: Accept the bet L3 and before the first coin flip buy 4 lotteries L1 ; then
if H buy 6 L1 , if T buy 3 L1 ; then if TH or HT buy 9 L1 . Check the final
cash-flows. Is this an arbitrage?

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