1. The Principle of Arbitrage
a. explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing derivatives;
What is a derivative?
- Derivatives are securities that derive their value from an underlying asset or benchmark.
- Common derivatives include futures contracts, forwards, options, and swaps.
What is the arbitrage-free price?
When the current price + risk-free borrowing rate equals the forward rate (future price) there is no arbitrage opportunity.
What is risk-neutral pricing?
Risk-neutral pricing is when an investor's risk aversion is not a factor in determining the derivative price.