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Martin Haugh
Garud Iyengar
Columbia University
Industrial Engineering and Operations Research
Linear pricing
Theorem. (Linear Pricing) Suppose there is no arbitrage. Suppose also
Price of cash flow cA is pA
Price of cash flow cB is pB
Then the price of cash flow that pays c = cA + cB must be pA + pB .
Let p denote the price of the total cash flow c. Suppose p < pA + pB , i.e. c is
cheap! Will create an arbitrage portfolio, i.e. a free-lunch portfolio.
Purchase c at price p
Sell cash flow cA and cB separately
Price of the portfolio = p pA pB < 0, i.e. net income at time t = 0.
The cash flows cancel out at all times. Future cash flows = zero. Free lunch!
No arbitrage no free lunch. Therefore, p pA + pB
We can reverse the argument if p > pA + pB
Note that we need a liquid market for buying/selling all the cash flows.
2
ct
(1+r)t .
PT
t=1
PT
ct
t=1 (1+r)t
pk
t =k 1
t=k
rk1 F
(1 + r0 )k1
(1 + r0 )k1
(1 + r0 )k1 (1 + rk1 )
(1 + r0 )k
Set =
F
.
(1+r0 )(k1)
deterministic
ck
(1+r)k
Fr0
(1+r)k
Recall that
n
Pf
X
F
+
pk
n
(1 + r0 )
k=1
F
+
(1 + r0 )n
n
X
k=1
Fr0
(1 + r0 )k
n
F
Fr0 X
1
+
(1 + r0 )n
(1 + r0 )
(1 + r0 )k1
k=1
1 (1+r1 0 )n
F
Fr0
+
1
(1 + r0 )n
(1 + r0 ) 1 1+r
0
1
(1+st )t .
PV =
A
(1 + st )t
Forward rate fuv : interest rate quoted today for lending from year u to v.
(1 + su )u
(1 + fuv )(vu)
(1 + sv )v
1
(1 + s )v vu
v
(1 + su )u