The pricing of contingent claims in the discrete time, discrete state case is analyzed from the perspective of linear programming duality. Absence of arbitrage and the existence of an equivalent martingale probability measure on security price filtrations are shown to be dual concepts. Writers of
contingent claims may make nonzero profits even for claims priced at their arbitrage price. Risk aversion does not change this conclusion, but spreads and margin requirements do make a difference.
By: Alan J. King
Published in: RC21153 in 1998
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