No arbitrage principle

Definition

The no arbitrage principle states that in efficient markets, it is impossible to achieve risk-free profits from price discrepancies of identical or similar financial instruments. This principle is foundational in finance, linking the concepts of pricing and investment strategies, ensuring that asset prices reflect their true value without opportunity for arbitrage profit.

5 Must Know Facts For Your Next Test

1. The no arbitrage principle underpins the pricing of derivatives and ensures consistency in pricing across markets.
2. It implies that any difference in price between two identical assets must be equalized by market forces, eliminating the potential for arbitrage opportunities.
3. In practical terms, if two assets have the same payoff and one is priced lower than the other, traders will buy the cheaper asset and sell the expensive one until prices converge.
4. The no arbitrage condition leads to the development of models such as the Black-Scholes model for option pricing.
5. Any persistent arbitrage opportunity would attract traders, driving prices to a point where no further risk-free profits can be made.

Review Questions

• How does the no arbitrage principle contribute to the pricing of financial derivatives?
  • The no arbitrage principle plays a crucial role in the pricing of financial derivatives by ensuring that derivatives are priced in line with their underlying assets. When derivatives like options are priced, they must reflect the expected payoffs of the underlying assets without allowing for risk-free profits. This alignment helps maintain market efficiency and prevents inconsistencies that could lead to arbitrage opportunities.
• Discuss how deviations from the no arbitrage principle can indicate inefficiencies in a market.
  • When deviations from the no arbitrage principle occur, it signals potential inefficiencies within a market. For example, if two identical assets are priced differently, it suggests that market participants have not fully recognized or acted upon the price discrepancy. Such situations can lead to mispricing, and as traders exploit these differences, market forces should ideally correct them, restoring balance and adherence to the no arbitrage principle.
• Evaluate the implications of the no arbitrage principle on investment strategies in modern finance.
  • The no arbitrage principle has significant implications for investment strategies in modern finance. It supports the development of various models used for pricing assets and derivatives, enabling investors to assess fair value accurately. Furthermore, it encourages a focus on portfolio diversification and risk management rather than seeking out arbitrage opportunities, which tend to diminish quickly in efficient markets. As a result, understanding this principle helps investors make informed decisions based on realistic expectations of returns and risks.

Related terms

Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from unequal prices.

Efficient Market Hypothesis: The theory that asset prices reflect all available information, making it impossible to consistently achieve higher returns than the overall market.

Risk-Free Rate: The theoretical return on an investment with zero risk, often represented by government bonds.