No-arbitrage principle

Definition

The no-arbitrage principle states that in efficient markets, identical assets must have the same price, or else arbitrage opportunities will exist, allowing traders to profit without any risk. This principle underlies much of modern financial theory and plays a crucial role in pricing financial derivatives and options. When markets are functioning properly, any discrepancies in pricing should quickly be corrected by traders seeking to exploit these opportunities.

5 Must Know Facts For Your Next Test

1. The no-arbitrage principle is foundational in the development of option pricing models like the Black-Scholes model.
2. If two assets have the same cash flows but different prices, arbitrageurs will buy the cheaper asset and sell the more expensive one until prices converge.
3. The principle is based on the assumption that markets are efficient and information is quickly reflected in asset prices.
4. Violations of the no-arbitrage principle can occur in practice due to transaction costs or market frictions, but they are typically short-lived.
5. Many financial instruments, including options and futures, rely on the no-arbitrage principle for their pricing mechanisms.

Review Questions

• How does the no-arbitrage principle influence the pricing of financial derivatives?
  • The no-arbitrage principle plays a critical role in determining the fair value of financial derivatives by ensuring that identical assets yield the same price. This means that if a derivative is mispriced, arbitrageurs will step in to buy or sell it until its price reflects its true value based on comparable assets. Consequently, the no-arbitrage condition is essential for constructing pricing models for options and other derivatives, ensuring they align with market realities.
• Evaluate how transaction costs can impact the effectiveness of the no-arbitrage principle in real-world markets.
  • In theory, the no-arbitrage principle ensures that identical assets should be priced similarly. However, in real-world markets, transaction costs can hinder arbitrage activities. If costs are too high, traders may not find it profitable to exploit price discrepancies, leading to prolonged mispricings. As a result, while the principle provides a guideline for pricing fairness, practical barriers like transaction fees can prevent it from holding true at all times.
• Critically analyze a scenario where the no-arbitrage principle fails and discuss its implications for investors and market stability.
  • Consider a situation where two similar stocks are trading at different prices due to market inefficiencies or information asymmetries. If one stock is undervalued compared to another with identical cash flows, arbitrageurs would typically act to correct this mispricing. However, if significant transaction costs or regulatory barriers exist, this correction may not occur swiftly. The failure of the no-arbitrage principle in such scenarios can lead to increased volatility and uncertainty for investors as they struggle to assess true asset values. This can erode trust in market efficiency and ultimately affect overall market stability.

Related terms

Arbitrage: The simultaneous buying and selling of an asset in different markets to profit from price discrepancies.

Financial derivatives: Financial contracts whose value is derived from the performance of an underlying asset, index, or interest rate.

Risk-neutral valuation: A method of valuing derivatives that assumes investors are indifferent to risk, allowing for the use of expected values to price options.