Implied-in-prices expectations: Their role in arbitrage

Sergei A. Ivanov

Abstract


Real prices are created on markets by supply and demand and they do not have to follow some distributions or have some properties, which we often assume. However, prices have to follow some rules in order to make arbitrage impossible. Existence of arbitrage opportunities means existence of inefficiency. Prices always contain expectations about future. Constraints on such expectations and arbitrage mechanisms were investigated with minimum assumptions about price processes (e.g. real prices do not have to be martingales). It was shown that found constraints could be easily failed in some widespread conditions. Fluctuating risk-free interest rates creates excess amount of asset in comparison with case when they are constant. This property allows arbitrage and making risk-free profit. This possibility is hard to use. However, in theory it exists almost on every market. Interest rate is implied in almost every price. The possibility exists where there is uncertainty about future. This leads to assumption that there is very fundamental inefficiency, which potentially is able to change markets dramatically.


Keywords


market efficiency, risk-neutral measure, interest rate, arbitrage, efficiency conditions

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DOI: http://dx.doi.org/10.1478/AAPP.92S1B1