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Unformatted text preview: Primbs, MS&E 345 1 The Linear Functional Form of Arbitrage Primbs, MS&E 345 2 Linear Pricing The basic argument What linear functionals look like A first step toward risk neutrality Girsanovs Theorem The Big Picture Summary Interpretation as state prices Primbs, MS&E 345 3 Linear Pricing The basic argument What linear functionals look like A first step toward risk neutrality Girsanovs Theorem The Big Picture Summary Interpretation as state prices Primbs, MS&E 345 4 Derivative pricing is nothing more than fitting data points with a linear function. Payoff Price x x Bond Stock The stock and bond are our data points Price=L(Payoff) The Big Picture Primbs, MS&E 345 5 Derivative pricing is nothing more than fitting data points with a linear function. Payoff Price x x Bond Stock Price=L(Payoff) The Big Picture To price a new payoff, we just evaluate our linear function. Call option Payoff x x x Call Price Primbs, MS&E 345 6 Linear Pricing The basic argument What linear functionals look like A first step toward risk neutrality Girsanovs Theorem The Big Picture Summary Interpretation as state prices Primbs, MS&E 345 7 Background: X L : We will consider a pricing functional: Price Payoff : L ) ( S S L T = Pricing the stock ) ( B B L T = Pricing the bond We need to define the space of payoffs. Consider the following example... Example: Primbs, MS&E 345 8 t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Stock Lattice Probability Space ) , , ( P Think of each as being a path for the stock (we want the entire path for path dependent derivatives.) The payoff can be a function of the path of the stock. ) ( T f Consider Primbs, MS&E 345 9 Background: X L : We will consider a pricing functional: Price Payoff : L Our space of payoffs should be: Payoff: ) ( T f (That is, functions of the path of the stock) ( 29 ) ( 2 P L (Technical condition) Primbs, MS&E 345 10 t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 An arbitrage is: ) ( )) ( , ( 2 P L f f T a (price, payoff) pair: with: )) ( , (  T f f That is, a positive payoff that has a negative price! You just receive cash flows! f and ) ) ( ( T f P or Primbs, MS&E 345 11 t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 The Basic Argument: Linearity: ) ( ) ( ) ( T T T T g L f L g f L + = + If there is a continuous strictly positive linear pricing functional, then there is no arbitrage. Strict Positivity: ) ) ( ( T f P )) ( ( T f L ) ( T f Primbs, MS&E 345 12 t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Assume there is a strictly positive linear pricing functional, Consider ) ) ( ( T f P ) ( T f with )) ( ( ) ) ( ( = f f L f P T T by positivity no arbitrage!...
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 Winter '10
 JIMPRIMBS

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