chapter1 - Chapter 1 No-Arbitrage Pricing of Simple...

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Chapter 1: No-Arbitrage Pricing of Simple Derivative Contracts 1 Chapter 1. No-Arbitrage Pricing of Simple Derivative Contracts In this chapter, we will present “ no-arbitrage principle ”, the most important principle in asset pricing theory. As a result of its simple applications to simple derivatives, the fair prices are given for forwards/futures and swaps . No-arbitrage principle is used to derive the “ upper bound ” and “ lower bound ” of options as well. The topic of this chapter is “static”, or in other words, one-step. The “dynamic” application of the “no-arbitrage principle” can be used to derive price of option and any other derivatives, as will be shown in the next chapter. The remainder of this chapter is as follows. In the first section, we introduce derivative contracts. Then we discuss the “Forward Market” in the second section. Ee discuss the “Swap Market” in the third section. In the last section, we present the “upper/lower bounds” for the option contracts by using simple no-arbitrage arguments. Section 1. Introduction to Derivatives Definition : A derivative is a security that pays its owner an amount that is a function of the values of other securities, called the underlying securities Key components : 1. Underlying asset 2. Functional relationship between the pay-off and underlying asset’s value Examples: 1. Forwards 2. Futures 3. Swaps 4. Options Derivative Markets : 1. Exchange Market
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Chapter 1: No-Arbitrage Pricing of Simple Derivative Contracts 2 2. Over-The-Counter Market (OTC) Derivative, as a financial product, is good or bad? This is a subject of considerable controversy. According to Warren Buffett (quoted from Berkeshire Hathaway report ): Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown. " Derivatives are financial weapons of mass destruction. The dangers are now latent--but they could be lethal ." On the hand, quoted from the Associated Press, The International Herald Tribune Online : “The chairman of the Federal Reserve Board, Alan Greenspan, taking issue with the warnings of the billionaire investor Warren Buffett, said Thursday that the growing use of complex financial instruments known as derivatives did not pose a threat to the financial system . Greenspan said investors who bought derivatives, including banks, had been able to spread their risks and that this had helped lessen the severity of the 2001 recession. "Even the
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