Arbitrage means taking advantage of price differences in different markets. In well-functioning markets, arbitrage opportunities are quickly exploited, and the resulting increased buying of underpriced assets and increased selling of overpriced assets return prices to equivalence.
Arbitrage and Derivatives
Assume the risk-free rate is 5%. The current price of gold is $300 per ounce and the forward price of gold is $330 in one year's time. Is there an arbitrage opportunity?
Here is what you can do:
Hence, a profit of $15 can be made without any risk!
In fact, any delivery price above $315 will result in a risk-free profit using this strategy.
What if the delivery price is $310?
Again, a profit of $5 can be made without any risk.
Investors in the gold market will take advantage of any forward price that is not equal to $315, eventually bring the price to $315, which is known as the arbitrage-free price.
The arbitrage principle is the essence of derivative pricing models.
Arbitrage and Replication
A portfolio composed of the underlying asset and the riskless asset could be constructed to have exactly the same cash flows as a derivative. This portfolio is called the replicating portfolio. Since they have the same cash flows, they would have to sell at the same price (the law of one price).
Assume the forward price of gold is $315 in one year's time, and the spot price is $300. You have $300.
Replication is the essence of arbitrage.
Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing
Risk-seeking investors give away a risk premium because they enjoy taking risk. Risk-averse investors expect a risk premium to compensate for the risk. Risk-neutral investors neither give nor receive a risk premium because they have no feelings about risk.
Risk-neutral pricing: Suppose you want to price a derivative. The payoff of this derivate can be replicated using the underlying asset and risk-free rate. The market price of this derivative and the replicating strategy must be exactly the same under the principle of no arbitrage, regardless of risk preferences.
To obtain the derivative price we should assume the investor is risk-neutral, because an investor's risk aversion is not a factor in determining the derivative price. Risk can be eliminated by dynamic hedging in a situation where there is no arbitrage possible. Once risk is eliminated in this way the expected return becomes equal to the risk-free rate for all investors. Assets can be assumed to grow at the risk-free rate and also discounted at the risk-free rate.
| jiba: You want to price a derivative on gold, a gold certificate. The product just pays the current price of an ounce in $.|
Now, how would you price it? Would you think about your risk preferences? No, you won't, you would just take the current gold price and perhaps add some spread. Therefore the risk preferences did not matter (=risk neutrality) because this product is derived (= derivative) from an underlying product (=underlying).
This is because all of the different risk preferences of the market participants is already included in the price of the underlying and the derivative can be hedged with the underlying continuously (at least this is what is often taken for granted). As soon as the price of the gold certificate diverges from the original price a shrewd trader would just buy/sell the underlying and sell/buy the certificate to pocket a risk free profit - and the price will soon come back again...
So, you see, the basic concept of risk neutrality is quite natural and easy to grasp. Of course, the devil is in the details... but that is another story.