Lesson 1 of 6 · 11 min
Arbitrage and the law of one price
Prices must leave no riskless profit on the table: identical cash flows must cost the same, and an asset with a known future price must trade at that price discounted at the risk-free rate.
In short
- Arbitrage is a riskless profit with no net investment. It exists when the law of one price fails: the same thing trades at two prices at the same time.
- For derivatives there are two arbitrage conditions: assets with identical future cash flows must have the same price today, and an asset with a known future price must trade at the present value of that price.
- With no other costs or benefits of ownership, the right discount rate is the risk-free rate.
- Discrete compounding, , is used for single assets; continuous compounding, , for portfolios such as indexes and for foreign exchange.
- Arbitrageurs buy the cheap side and sell the dear side, which pushes the prices together until the profit disappears.
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