Reading 69: Arbitrage, Replication, and Carry Costs

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Book 3: Derivatives

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7 Terms

1
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Arbitrage

a transaction in which an investor purchases one asset at one price and simultaneously sells an asset that has the same future payoffs at a higher price

2
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No-Arbitrage Condition

two portfolios with the same payoff in the future for any value of the underlying will have the same cost today

3
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Replication

creating a portfolio with cash market transactions that has the same payoffs as a derivative for all possible values of the underlying

4
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No Arbitrage Forward Price =

S(1+r)^T

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No Arbitrage Forward Price with Costs and Benefits =

[S + PV(costs) – PV(benefits)](1+r)^T

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FV with continuously compounded return =

Se^rT

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PV with continuously compounded return =

Se^-rT