Derivatives: Law of one price

Posted on Posted in Investment Banking

Valuation of derivatives is different than the valuation of equities. Before we understand “Law of one price”, let us see some jargons.

Arbitrage: If you can buy an asset at lower price and immediately sell it at higher price with no risk, then it is called Arbitrage. Replication is essence of arbitrage.

Replication: Creation of an asset or portfolio from another asset or portfolio. For example, you can either buy gold directly or you can buy equity linked to price of gold.

Law of one price: Also called arbitrage principal. Evaluate present value of future cash flow using below formula

Asset + Derivative = Risk-free Asset

Application of “Law of one price”: Example is – “Put-Call Parity”

Put-Call Parity: Protective Put = Fiduciary Call

Where, Protective Put = Asset + Put Option; and Fiduciary Call = Call Option + Risk free asset

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