The Arbitrage Theorem

27.01.2020

1 Arbitrage Theorem
Suppose an experiment results in m possible outcomes and there are n wagers
(i.e n types of bets). Wager i gets a return xrij if x is bet on on wager i
when the outcome of the experiment is j. Let Rn×m be the matrix of returns
in which the (i, j)th element is rij .

Theorem 1. The Arbitrage Theorem: Either there exists a probability vector

p of dimension m such that Rp = 0
OR
There exists a betting strategy vector x of dimension n such that xT R > 0.

Suppose there exists a probability vector p such that Rp = 0. If there

exists an x such that xT R > 0, then (xT R)p > 0. But, (xT R)p = xT (Rp) =
xT b × 0 = 0 which is a contradiction. Therefore, when Rp = 0, there is no x
such that xT R > 0.
Similarly, if there is an x such that xT R > 0, we cannot find any p ≥ 0 such
that Rp = 0. However, the theorem asserts that if there is no p such that
Rp = 0, then we can find an x such that xT R > 0. This can be proved by
using Linear Programming.
When Rp = 0 for a probability vector p, we say that all bets are fair and
the probabilities are risk-neutral probabilities. Otherwise there is a betting
scheme that guarantees a win.

Example:
Let R is a m × m square matrix, such that the ith diagonal element is αi and
all off-diagonal elements are −1. If a risk-neutral probability vector p exists,
1 1
then it is necessary that pi = 1+α i
and hence Σ 1+α i
= 1. If this condition is
not satisfied then there is arbitrage and we can find an x such trhat xT R > 0.
Question:

1
Is arbitrage
[ possible
] when
4 8 −10
R= ?
6 12 −16

2 Multi-period Binomial Model

Let S(i) be the stock price at time period i, i = 1, 2, ..., n. Suppose S(i) =
uS(i − 1) or dS(i − 1) where d < 1 + r < u, r the interest rate per period.
The call option for strike price K is such that it is exercisable after the nth
period. In addition, it is also possible to buy and sell the stock at any period
i < n. Under this situation, what must be the cost of the call option under
no arbitrage opportunity ?
If Xi denotes the r.v taking valu 1 when S(i) = uS(i − 1) and 0 when
S(i) = dS(i − 1), the outcomes of this experiment are the set of vectors
(X1 , X2 , ..., Xn ). The return matrix will have 2n columns in this case. The
wagers are 1, 2, ..., n − 1. The matrix R will be unwieldy. We can handle the
case for each ith wager. The ith wager buys the stock at the i − 1th period
and sells it at the ith period thereby getting the price S(i) which is either
uS(i − 1) or dS(i − 1). The expected present value of gain in the process
that takes place at the (i − 1)th period is:
p(1 + r)−i [puS(i − 1) + (1+)−i (1 − p)dS(i − 1)] − (1 + r)−(i−1) if P (Xi = 1) =
p, i = 1, 2, ..., n.
This is the case irrespective of what the random variables other than Xi may
take.
Now, the above wager has no arbitrage implies that the expected gain is 0
implying that
p = 1+r−d
u−d
.
The above value of p ensures that there is no arbitrage at any period before
n. Now, at the end of period n, The value of the share is:
S(0)us dn−s where s is the sum of n Xi . The present value of gain at the end
of nth period is (1 + r)−n (S(n) − K)+ . The expected present value of the
gain must be the cost of the call option C, in order that there is no arbitrage.
Hence, C = (1 + r)−n E(S(0)us d(n−s) − K)+
which is evaluated using the Binomial distribution with parameters n and p
where p is as derived above.