Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
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Introduction
Earlier derivative lessons established the features of derivative instruments and markets and addressed both the benefits and risks associated with their use. Forward commitments and contingent claims were distinguished by their different payoff profiles and other characteristics. We now turn our attention to the pricing and valuation of these instruments. As a first step, we explore how the price of a forward commitment is related to the spot price of an underlying asset in a way that does not allow for arbitrage opportunities. Specifically, the strategy of replication shows that identical payoffs to a forward commitment can be achieved from spot market transactions combined with borrowing or lending at the risk-free rate. Finally, the second lesson demonstrates how costs or benefits associated with owning an underlying asset affect the forward commitment price.
Learning Outcomes
The candidate should be able to:
- explain how the concepts of arbitrage and replication are used in pricing derivatives
- explain the difference between the spot and expected future price of an underlying and the cost of carry associated with holding the underlying asset
0.75 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.