1. Financial Market Theory
Tuesday, September 4, 2018
Professor Edwin T Burton

2. Today, we will do two things
1. Wrap up our discussion of the risk free rate and arbitrage
2. Begin the discussion of the role of bankruptcy in finance
September, 4, 2018

3. A Key Assumption Made Throught This Course
We will always assume, in this course, that anyone can either borrow or lend at the risk free rate
As strange as it may sound, this assumption is actually true in the real world for any investor with substantial assets, including all pension funds, endowments, and foundations, though they may not know it.
This simple assumption enables us to price many securities and contracts (such as derivative contracts like futures and options) with some precision.
In one way or another, this assumption underlies all considerations of value in financial markets
September, 4, 2018

4. The Concept of a Risk Free Asset
A risk free asset has a fixed return that is exactly the same regardless of what events occur in the future
This fixed return might be negative. It just can’t vary depending upon future events
September, 4, 2018

5. “The” Risk Free Asset
“The” risk free asset is the risk free asset that has the highest return among all risk free assets
“The” risk free rate is the rate of interest (return) of “the” risk free asset
Because of arbitrage, all risk free assets should earn the “risk free rate” – more on this later
September, 4, 2018

6. Arbitrage in practice
Using the assumption, that anyone can borrow or lend at the risk free rate, we obtain the following general conclusions, if the “no-arbitrage” assumption is valid:
No riskless transaction can earn more than the risk free rate
No riskless transaction can earn less than the risk free rate
The implications of these conclusions are enormous in the real world, as they enable us to immediately price many financial instruments (whose prices are unknown), merely by know the current price of other financial instruments.
September, 4, 2018