ARBITRAGE-FREE PRICING IN COMPLETE MARKETS
ARBITRAGE-FREE PRICING IN COMPLETE MARKETS
The author describes one of the breakthrough concepts of modern finance: the use of the no arbitrage principle in complete markets as the basis for the powerful mathematics of “risk neutral” or “equivalent martingale” pricing. This neoclassical finance model relies on two intertwined assumptions: the existence of complete markets, and the assumption that market participants will act to ensure that no arbitrage profits are possible. The author then presents strong evidence that both of these assumptions are lacking for private businesses and their investors, because markets for the equity in these firms are incomplete. The author argues that this severely undermines this model as a practical valuation tool. As with other principles, this assertion is tested by applying it to three actual companies.
Keywords: neoclassical finance, no-arbitrage principle, arbitrage free pricing, risk neutral, First Fundamental Theorem of Finance, equivalent martingale, complete markets, incomplete markets, state pricing
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