In derivatives markets, arbitrage is the certainty of profiting from a price difference between a derivative and a portfolio of assets that replicates the derivative’s cashflows. Derivatives are priced using the no-arbitrage or arbitrage-free principle: the price of the derivative is set at the same level as the value of the replicating portfolio, so that no trader can make a risk-free profit by buying one and selling the other. If any arbitrage opportunities do arise, they quickly disappear as traders taking advantage of the arbitrage push the derivative’s price until it equals the value of replicating portfolios.
NO-ARBITRAGE PRICING
