**Are you an EPFL student looking for a semester project?**

Work with us on data science and visualisation projects, and deploy your project as an app on top of GraphSearch.

Concept# Rational pricing

Summary

Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. Where this mismatch can be exploited (i.e. after transaction costs, storage costs, transport costs, dividends etc.) the arbitrageur can "lock in" a risk-free profit by purchasing and selling simultaneously in both markets.
In general, arbitrage ensures that "the law of one price" will hold; arbitrage also equalises the prices of assets with identical cash flows, and sets the price of assets with known future cash flows.
The same asset must trade at the same price on all markets ("the law of one price").
Where this is not true, the arbitrageur will:
buy the asset on the market where it has the lower price, and simultaneously sell it (short) on the second market at the higher price
deliver the asset to the buyer and receive that higher price
pay the seller on the cheaper market with the proceeds and pocket the difference.
Two assets with identical cash flows must trade at the same price. Where this is not true, the arbitrageur will:
sell the asset with the higher price (short sell) and simultaneously buy the asset with the lower price
fund his purchase of the cheaper asset with the proceeds from the sale of the expensive asset and pocket the difference
deliver on his obligations to the buyer of the expensive asset, using the cash flows from the cheaper asset.
An asset with a known price in the future must today trade at that price discounted at the risk free rate.
Note that this condition can be viewed as an application of the above, where the two assets in question are the asset to be delivered and the risk free asset.

Official source

This page is automatically generated and may contain information that is not correct, complete, up-to-date, or relevant to your search query. The same applies to every other page on this website. Please make sure to verify the information with EPFL's official sources.

Related publications (43)

Related concepts (24)

Related people (5)

Related courses (16)

Related units (3)

Related lectures (56)

Forward rate agreement

In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs). A forward rate agreement's (FRA's) effective description is a cash for difference derivative contract, between two parties, benchmarked against an interest rate index. That index is commonly an interbank offered rate (-IBOR) of specific tenor in different currencies, for example LIBOR in USD, GBP, EURIBOR in EUR or STIBOR in SEK.

Fundamental theorem of asset pricing

The fundamental theorems of asset pricing (also: of arbitrage, of finance), in both financial economics and mathematical finance, provide necessary and sufficient conditions for a market to be arbitrage-free, and for a market to be complete. An arbitrage opportunity is a way of making money with no initial investment without any possibility of loss. Though arbitrage opportunities do exist briefly in real life, it has been said that any sensible market model must avoid this type of profit.

Option (finance)

In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction.

FIN-404: Derivatives

The objective of this course is to provide a detailed coverage of the standard models for the valuation and hedging of derivatives products such as European options, American options, forward contract

FIN-609: Asset Pricing (2011 - 2024)

This course provides an overview of the theory of asset pricing and portfolio choice theory following historical developments in the field and putting
emphasis on theoretical models that help our unde

MATH-470: Martingales in financial mathematics

The aim of the course is to apply the theory of martingales in the context of mathematical finance. The course provides a detailed study of the mathematical ideas that are used in modern financial mat

We analyze and implement the kernel ridge regression (KR) method developed in Filipovic et al. (Stripping the discount curve-a robust machine learning approach. Swiss Finance Institute Research Paper No. 22-24. SSRN. https://ssrn.com/abstract=4058150, 2022 ...

Multiperiod Binomial Pricing

Covers the concept of multiperiod binomial pricing and the Black-Scholes formula.

Generalized Method of Moments (GMM)

Introduces the Generalized Method of Moments (GMM) in econometrics, focusing on its application in instrumental variable estimation and asset pricing models.

Economic Arbitrage: Real EstateMOOC: Soil and real estate economy

Explores economic arbitrage in real estate decision-making, using practical examples and mathematical notations.

In this thesis we present three closed form approximation methods for portfolio valuation and risk management.The first chapter is titled ``Kernel methods for portfolio valuation and risk management'', and is a joint work with Damir Filipovi'c (SFI and EP ...

This thesis investigates the relationship between investors' demand shocks and asset pricesthrough the use of data on portfolio holdings. In three chapters, I study the theory, estimation,and application of demand-based asset pricing models, which incorpor ...