Lecture of Arbitrage Pricing Theory

Prof. Derdenger

Carnegie Mellon University

Tepper School of Business

Prof. Derdenger (CMU) 1 / 12

Arbitrage Pricing

Some features of the solution to a market game are evident without

explicitly solving the game.
Perhaps the most important one comes from the notion of arbitrage,
which is based on payo¤ equivalence.
Two bundles of securities are payo¤ equivalent if they have the same
probability distribution determining the payo¤s at the end of the
game.
The optimal exploitation of arbitrage opportunities puts bounds on
the best prices quoted in the limit order book of payo¤ equivalent
portfolios.
Loosely speaking, arbitrage compels payo¤ equivalent securities to
trade at the same price.
More precisely, it should not be possible, by means of market orders
alone, to sell one bundle of securities and purchase another payo¤
equivalent bundle and make a net pro…t.
Prof. Derdenger (CMU) 2 / 12
Arbitrage Pricing
Arbitrage relies on a fundamental principle of …nance: the law of one
price says – security must have the same price regardless of the means
of creating that security.
Implies – if the payo¤ of a security can be synthetically created by a
package of other securities, the price of the package and the price of
the security whose payo¤ replicates must be equal.
How can you produce an arbitrage opportunity involving securities A,
B,C?
Security Price Payo¤ in State 1 Payo¤ in State 2
A $70 $50 $100
B $60 $30 $120
C $80 $38 $112
Replicating Portfolio:
combine securities A and B in such a way that replicate the payo¤s of
security C in either state
Let wA and wB be proportions of security A and B in portfolio
Prof. Derdenger (CMU) 3 / 12
Arbitrage Pricing
Payo¤ of the portfolio
in state 1 : 50wA + 30wB
in state 2 : 100wA + 120wB
Create a portfolio consisting of A and B that will reproduce the payo¤
of C regardless of the state that occurs one year from now.
in state 1 : 50wA + 30wB = $38
in state 2 : 100wA + 120wB = $112
Solving equation system, weights are found wB = 0.6 and wA = 0.4
An arbitrage opportunity will exist if the cost of this portfolio is
di¤erent than the cost of security C.
Cost of the portfolio is 0.4 x $70 + 0.6 x $60 = $64 - price of security
C is $80. The “synthetic” security is cheap relative to security C .
Riskless arbitrage pro…t is obtained by “buying A and B” in these
proportions and “shorting” security C .
Prof. Derdenger (CMU) 4 / 12
Arbitrage Pricing in Limit Order Markets

Suppose there are J securities labeled as j 2 f1, 2, ..., J g

let qj denote the amount of asset j traded by and investor
if qj > 0 investor bought asset j
if qj < 0 investor sold asset j
Let pj > 0 denote the market prices of the j th assest

Aj if qj > 0
pj
Bj if qj < 0

Let vj > 0 denote the expected present value of the dividend stream
plus the liquidation value of the j th assest
The Arbitrage Pricing Theory (APT) says:

J
∑ (vj pj )qj 0
j =1

Prof. Derdenger (CMU) 5 / 12

Arbitrage Pricing in Limit Order Markets
An Example: Telecommunications provider

Imagine there are three market segments in the telecom sector.

Some consumers want wireless only, others just cable, while a third
segment demands a wireless/cable comination service
A …rm provides:
q1 quantity of wireless services
q2 quantity of cable services
q3 quantity of cable and wireless services
Suppose scale economies in marketing are realized from emphasizing
any one segment. The …rm’s value is
3
max fvj qj g + ∑ vj qj
j 2f1,2,3 g j =1

where
v1 is the demand factor for wireless
v2 is the demand factor for cable
v3 = 2v1 + v2
Prof. Derdenger (CMU) 6 / 12
Arbitrage Pricing in Limit Order Markets
The only way to achieve production e¢ ciency in this sector is for every …rm
to specialize in one of the three market segments. We assume this happens,
and analyze the resulting arbitrage conditions.
For arbitrage to be not present we need pricing in the …rst two segments to
follow for j 2 f1, 2g :
2v j Aj
Bj 2v j
and for the third sector
4v 1 +2V 2 A3
4v 1 +2v 2 B3
Putting the four sets of inequalities together we obtain two inequalities in
terms of prices
(revenue from selling) 2B 1 +B 2 A3 (cost of buying)
(cost of buying) 2A1 +A2 B3 (revenue from selling)
Prof. Derdenger (CMU) 7 / 12
E¢ cient Market hypothesis
An Example

Suppose U.S. export companies sporadically receive Euro and yuan

injections from demanders for their goods in the E.U. between dates 0
and T.
Similarly European (and Chinese) exporters sporadically receive
injections of dollars and yuan (euros) for their sales in the U.S. and
China (Europe).
Export …rms in each country also purchase domestic currency on the
foreign exchange market between date 0 and T. At date T all export
companies are liquidated and no further value is placed on holding
foreign currency.
We assume the U.S. dollar is a dominant currency, meaning all
currency prices are quoted in dollars.

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E¢ cient Market hypothesis
An Example

Prof. Derdenger (CMU) 9 / 12

E¢ cient Market Hypothesis

We assume each export …rm maximizes its expected dividend

payments paid in domestic currency before the liquidation date T.
The liquidation value is unknown at all dates t < T, but as new
information arrives about foreign trade throughout the trading phase,
the traders become more informed about the value of foreign currency.
In competitive equilibrium the price of each exporter is the expected
value of its dividend ‡ow plus its liquidation value.
Therefore the exchange rates follow a random walk.

Prof. Derdenger (CMU) 10 / 12

E¢ cient Market Hypothesis

PROVING EFFICIENT MARKET HYPOTHESIS

Suppose the price of one yuan in terms of dollars is higher in date t
than its expected price in date s > t.
Chinese exporters buying yuan at date t are not maximizing their
value, because the expected value of their companies would be higher
if they postponed yen purchases until date s. This contradicts EMH.
Exports would not buy yuan in period t causing demand in period t to
decrease resulting in the price of one yuan in terms of dollars to
decrease
Thus EMH says prices today must be less than the expected price
tomorrow given today’s information
Similar arguments apply to the dollar euro exchange market.

Prof. Derdenger (CMU) 11 / 12

Summary

We de…ned and discussed the main features of limit order markets,

including limit orders, market orders, and picking o¤ risk.
We explained some issues of concern to regulators, such as ‡ash
trading, inside trading and front running.
We showed how arbitrage pricing theory (APT) can be rederived quite
simply within limit order markets, inequalities rather than equalities
de…nning how asset bid-ask prices are linked across assets formed
from di¤erent combinations of latent factors.
Similarly the E¢ cient Markets Hypothesis (EMH) was restated within
a limit order market, again in the weaker form of inequalities rather
than equalities.

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