Derivative Background

Abstract

The main focus of this book is the pricing of financial assets. Price formation in financial markets may be explained in an absolute manner in terms of fundamentals, as, e.g. in the so-called rational expectation model, or, more modestly, in a relative manner explaining the prices of some assets in terms of other given and observable asset prices. The second approach, which we adopt, is based on the concept of arbitrage. This remarkably simple concept is independent of beliefs and tastes (preferences) of the actors in the financial market. The basic assumption simply states that all participants in the market prefer more to less, and that any increase in consumption opportunities must somehow be paid for. Underlying all arguments is the question: Is it possible for an investor to restructure his current portfolio (the assets currently owned) in such a way that he has to pay less today for his restructured portfolio and still has the same (or a higher) return at a future date? If such an opportunity exists, the arbitrageur can consume the difference today and has gained a free lunch.