Abstract

Arbitrage in its most basic form involves the simultaneous buying and selling of an asset at two different prices in two different markets. In real-world financial markets, arbitrage opportunities rarely, if ever, exist. Less obvious arbitrage opportunities exist in situations where a package of assets can be assembled that have a payoff (return) that is identical to an asset that is priced differently. A market is said to be a complete market if an arbitrary payoff can be replicated by a portfolio. The most fundamental principle in asset pricing theory is the absence of arbitrage opportunities. Keywords: absence of arbitrage; finite-state; arbitrage; law of one price; state prices; risk-neutral probabilities; complete markets; state-price deflator; propagation of information; equivalent martingale measures; equivalent probability measures

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