06-RettoLin(f)

06-RettoLin(f) - Primbs, MS&E 345 1 From the...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Primbs, MS&E 345 1 From the Return Form to the Linear Functional Form of Arbitrage Primbs, MS&E 345 2 Pricing Theory: Optimization Return form (pdes) Linear function form (risk neutral) Primbs, MS&E 345 3 Pricing Theory: Return form (pdes) Linear function form (risk neutral) Optimization Primbs, MS&E 345 4 The Linear Functional Form of Arbitrage: What is the return form lacking? r rdt B dB = B B(1+r) d dt S dS + = S ) 1 ( + + S ) 1 ( + S There is a clear arbitrage opportunity! The return form doesnt capture it! Consider the following example: Primbs, MS&E 345 5 In our example, does there exist a such that: =- r Yes! of course! Something is missing from the return form. The return form is a necessary condition for no arbitrage, but it is not sufficient. Lets return to the basics... The return form doesnt capture it! Primbs, MS&E 345 6 What is an arbitrage opportunity? t v u dt t v + d dt t v + price payoff If we plot all the cash flows associated with the purchase of a portfolio v , there must be some positive and some negative cash flows....
View Full Document

This note was uploaded on 06/17/2010 for the course MS&E 345 taught by Professor Jimprimbs during the Winter '10 term at Stanford.

Page1 / 15

06-RettoLin(f) - Primbs, MS&E 345 1 From the...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online