explain the no arbitrage argument for option pricing, in particular the concept of riskless hedge

Expert Solution

Under the law of no arbitrage, price of a derivative must equal the replicating portfolio's price. We know that a riskless hedged can be created by buying delta shares of stock and simultaneously selling call option on that stock and ending up with a riskless position. The position is riskless as it does not depend on the outcome, the value or payoff in future is guaranteed or fixed or certain. Therefore, the expected rates of return of all securities must be the riskless rate when investors are risk-neutral.

A riskless arbitrage opportunity is one that, without any initial investment, generates nonnegative returns under all circumstances and positive returns under some. In an efficient market, such opportunities do not exist (for long). Hence, we can use the concept of no aribtrage riskless hedging to price a derivative.

jeff jeffy answered 2 years ago

Can you please explain no pricing arbitrage theory for option pricing in detail? Take an example...

Can you please explain no pricing arbitrage theory for option pricing in detail? Take an example and do it excel. Please keep it neat and simple. Show all formulas in excel.

What is the objective of a hedge portfolio in the Binomial Option Pricing Model?

Explain the following terms: option, spread, and arbitrage.

Please separately explain wether these five hedges (future hedge, forward hedge, option hedge, money market hedge...

Please separately explain wether these five hedges (future hedge, forward hedge, option hedge, money market hedge and swap hedg) increases firm value？

1. Describe the riskless arbitrage strategies, that will yield the CAPM alpha and the Carhart alpha...

1. Describe the riskless arbitrage strategies, that will yield the CAPM alpha and the Carhart alpha as the expected return. (Hint: The momentum factor buys recent winners and shorts recent losers) 2. Do you think that the alpha from question 1 overesitamtes or underesimates the abnormal return you should expect to get from the short side of your stratgy going forward? (Hint: think about what is likely to have happend to the stocks you decided to short. The loading on...

Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. Bank...

Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. Bank A Bank B Bid price of USD GHS 5.72 GHS 5.55 Ask Price of USD GHS 5.85 GHS 5.65 Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had GHS10 million to use. What market forces would occur to eliminate any further possibilities of locational arbitrage?

Critically evaluate the use of Arbitrage Pricing Theory (model) in asset pricing.

Althea the arbitrageur wants to make a riskless profit by attempting covered interest arbitrage. She has...

Althea the arbitrageur wants to make a riskless profit by attempting covered interest arbitrage. She has $1,000,000 and sees the following spot and forward rate quotes offered: Spot = $1.40/Euro Forward180 day = $1.42/Euro Alana can earn 5% interest per annum on a 1-year US government bond and 3% interest per annum on the equivalent French bond. Assuming Alana can sell either bond after six months for the same price she paid, excluding trading costs does Alana...

1. Althea the arbitrageur wants to make a riskless profit by attempting covered interest arbitrage. She...

1. Althea the arbitrageur wants to make a riskless profit by attempting covered interest arbitrage. She has $1,000,000 and sees the following spot and forward rate quotes offered: Spot = $1.40/Euro Forward180 day = $1.42/Euro Alana can earn 5% interest per annum on a 1-year US government bond and 3% interest per annum on the equivalent French bond. Assuming Alana can sell either bond after six months for the same price she paid, excluding trading costs does Alana have an...

How the concept of arbitrage can generally be used to explain exchange rate movements?

Question