A stock worth 100 today will be worth 80, 100 or 120 after one period, and cash earns no interest. What should a call with strike 100 cost? With three states and only two traded payoffs, no portfolio reproduces the call, and no arbitrage alone gives a range of prices rather than one number. This lesson relates completeness to the rank of the payoff matrix and to the uniqueness of the pricing measure, computes the open interval of arbitrage-free call prices, and shows that its endpoints are the superhedging and subhedging costs.
Key terms
Attainable claim
Definition Consider a one-period market with states, each with positive physical probability, and traded instruments. Their prices today form the vector , and their payoffs form the payoff matrix , whose entry is the payoff of instrument in state . Trading is frictionless, so a portfolio with entries of either sign costs and pays . A claim, a payoff vector , is attainable if for some , so the attainable claims form the column space . Under NA every portfolio that replicates an attainable claim has the same cost, and this cost equals for every strictly positive state-price vector , that is every with , because
When the account, which costs and pays in every state, is traded, this common value is for every EMM .
In plain words A claim is attainable when some portfolio of the traded instruments pays exactly the claim in every state. In an arbitrage-free market the claim then has one price, the cost of that portfolio, and every pricing measure gives it the same value.
Example Take three states, cash that costs and pays in every state, and a stock that costs and pays , or . A portfolio of in cash and shares pays when the terminal stock price is , so the attainable claims are exactly the affine functions of the terminal price. The claim is attainable with and , at the cost . The call with strike , which pays , is not attainable. Its payoff rises by from to and by from to , while an affine function rises by equal amounts over these two equal steps.
Market completeness
Definition The market is complete if every claim is attainable, that is if , or equivalently . A finite one-period market that satisfies NA and trades the account is complete if and only if its state-price vector is unique, and then its EMM for the account is unique too. If , then has trivial null space, so has at most one solution. If , there is a with . Starting from a strictly positive solution , which exists under NA, the vectors and are strictly positive for small , both solve , and they differ. Because the account is traded, every solution satisfies , so turns distinct state-price vectors into distinct EMMs. Completeness is relative to the modeled states and information. Splitting one state into two makes a complete market incomplete unless an instrument is added whose payoff tells the two apart.
In plain words A complete market can reproduce every payoff on the modeled states, so every claim has one price. In a finite arbitrage-free market this happens exactly when the traded prices pin down the pricing measure.
Example The two-state market of the earlier lessons, with cash that costs and pays and a stock that costs and pays or , has the payoff matrix
with determinant . Its rank is , so it is complete, and its unique EMM has the weights and . A binomial tree is complete in the same way node by node, with only the stock and the account, because each node has two successors and the hedge is rebalanced at every node. The three-state market of the first card has rank , and its EMMs form a one-parameter family.
Payoff matrix rank
Definition The rank of the payoff matrix is the number of linearly independent payoff columns. It equals the number of linearly independent rows and the dimension of the space of attainable claims, and . A new instrument raises the rank only when its payoff is not already a combination of the existing payoffs, and under NA an instrument whose payoff is must cost . Under NA the solutions of form an affine set of dimension , and the strictly positive ones form a nonempty, relatively open subset of it with the same dimension. So counts the free directions left in the pricing measure.
In plain words The rank counts how many genuinely different payoff directions the market offers. Counting instruments is not enough, because an instrument that copies a combination of others adds a price constraint but no new direction.
Example In the three-state market the cash and stock columns are independent, so the rank is . Adding the call gives
which is not zero, so the rank becomes and the extended market is complete. Adding the put with strike , which pays , as a fourth instrument leaves the rank at , since the put pays the call minus the stock plus in cash. Four instruments then span only three directions.
Incomplete market
Definition A finite market is incomplete if , so some claims are not attainable. Under NA it then has infinitely many EMMs, by the completeness result. Every attainable claim gets the same value under all of them, while every unattainable claim gets different values under some pair of them, since some with has exactly when is not in . Incompleteness is not arbitrage. Each EMM gives a consistent arbitrage-free system of prices, and the no-arbitrage condition alone does not choose among them.
In plain words The traded instruments leave some payoff directions uncovered. Their prices constrain the pricing measure without determining it, and a claim that loads on a missing direction is left with a range of values.
Example In the three-state market with zero interest, let , and be the pricing weights of the terminal stock prices , and . Cash and stock give the two equations
where the second is the stock equation divided by . Subtracting five times the first gives , so and , and full support requires . The call with strike has the value . The choices , and give the measures , and and the call values , and , while the attainable claim is worth under each of them.
No-arbitrage price interval
Definition Let a finite one-period market with full support and frictionless trading trade the account and satisfy NA, and let be a claim. A price for is arbitrage-free if the market extended by as a new instrument with price still satisfies NA. By the fundamental theorem applied to the extended market, the arbitrage-free prices are exactly the numbers
which are the values over all EMMs . This set is an interval, because the strictly positive state-price vectors form a convex set. If is attainable it is a single point, the replication cost. If is not attainable it is an open interval
with , whose endpoints are the subhedging and superhedging bounds of the next card, and neither endpoint is an arbitrage-free price.
In plain words No arbitrage alone does not price an unattainable claim. It leaves a range of prices, each consistent with at least one pricing measure, and the ends of the range are excluded because trading the claim there creates an arbitrage.
Example In the three-state market the call has the value with , so its arbitrage-free prices form the open interval , and a quoted price inside it selects the measure with . At , buying the call costs nothing and pays in the top state, which is an arbitrage. At , selling the call and buying half a share with borrowed costs and pays
which is nonnegative and positive in the middle state, again an arbitrage.
Superhedging bound
Definition In the market of the previous card, the superhedging bound of a claim is the smallest cost of a portfolio that pays at least in every state, and the subhedging bound is the largest cost of a portfolio that pays at most in every state,
with the inequalities taken coordinate by coordinate. A seller who receives can buy an optimal superhedge and meet the claim in every state, so is the seller’s bound, and is the buyer’s bound in the same way. Because the account pays in every state, both problems are feasible, and under NA linear programming duality gives
where is the set of nonnegative state-price vectors, all with . All four optima are attained. The set contains boundary vectors with zero entries, which do not give measures equivalent to . Under NA every point of is a limit of strictly positive state-price vectors, so the bounds are also the supremum and the infimum of over the EMMs. For an unattainable claim an optimal superhedge has and , so selling at and buying costs nothing and pays the nonnegative nonzero vector , an arbitrage. The same argument with an optimal subhedge excludes . The closed bounds are therefore the ends of the open interval of arbitrage-free prices, not members of it.
In plain words The superhedging bound is the least a seller needs to cover the claim in every state without risk, and the subhedging bound is the most a buyer can pay while still hedging to a result that is nonnegative in every state. They bracket every arbitrage-free price, but for an unattainable claim they are not arbitrage-free prices themselves.
Example For the call in the three-state market, a portfolio pays the affine function of the terminal price , and with zero interest and it costs . A superhedge needs and , and since is the midpoint of and ,
Half a share with borrowed pays and costs , so . A subhedge needs , so its cost is at most , and the empty portfolio attains this, so . On the dual side, the boundary measures with and , which are and , give the values and . They price the cash and the stock, but each puts zero weight on a possible state.
Check yourself
- In the three-state market a dealer offers a second asset that pays , and and costs . Does it complete the market, and is an arbitrage-free price?
Show the answer
It does not complete the market, and is not arbitrage-free. Its payoff is , two shares minus in cash, so its column is a combination of the existing columns and the rank stays . That portfolio costs , so the law of one price allows only the price . At , sell the asset and buy two shares with borrowed. This brings in today, and at the end the two shares minus the loan pay exactly what the asset pays, so the positions cancel in every state. Depositing the in cash at zero interest gives in every state at no cost, which is an arbitrage.
- In the three-state market the put with strike pays . Find its interval of arbitrage-free prices and its two hedging bounds. A dealer then quotes the call at and the put at , each inside its own interval. Are the two quotes together arbitrage-free?
Show the answer
Under the measure the put is worth , so its arbitrage-free prices form the interval , the same as for the call. A superhedge needs and , so , and selling half a share while holding in cash pays at the cost , so the superhedging bound is . A subhedge needs , and the empty portfolio gives the subhedging bound .
The two quotes are not jointly arbitrage-free. The call minus the put pays , which is the stock minus in cash and costs , so every EMM gives the call and the put the same value . With the quotes and , buy the call, sell the put and sell one share short, which brings in , and deposit this amount. At the end the call minus the put pays , buying back the share costs , and the deposit pays , so the position ends with in every state. Separate intervals for two claims do not describe their joint prices, because a price for one of them already fixes .
- A straddle that pays , which is , starts trading in the three-state market at the price . Show that the market becomes complete, find its unique EMM and the price of the call, and give a portfolio of cash, stock and straddle that replicates the call.
Show the answer
The straddle is worth under the measure , so its arbitrage-free prices form the interval , and the price requires . This lies inside , so the extended market is arbitrage-free with the EMM . The new payoff matrix has
which is not zero, so its rank is , the market is complete, and the EMM above is the only one. The call is then worth . The straddle plus one share minus in cash pays , twice the call, so the call is replicated by half a straddle, half a share and a loan of . This portfolio pays , and in the three states, and it costs , the same as the EMM value.