Pricing by Arbitrage

In a futures contract, for no-arbitrage to be possible, the price paid on delivery must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk-free rate.

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by accumulating the present value S(t) at time t to maturity T by the rate of risk-free return x.

Any deviation from this equality allows for arbitrage. It involves

  1. Simultaneous buying and selling.
  2. No initial investment.
  3. Making riskless profits net of transaction costs.

Leave a Comment

Share to...