INTRODUCTION

An arbitrage opportunity refers to the possibility of deriving instantaneous profit without any risk. For instance, suppose gold is being sold at 400 dollars per ounce in city I but 399.90 dollars in a different city II. Then a trader can buy gold from city II and sell it in city I to make a riskless profit of 10 cents per ounce. This is arbitrage. That is, an arbitrage opportunity represents the production of something out of nothing. The non-arbitrage principle means the rule of a single price. The key principle behind the idea of asset pricing in financial economics is the principle of non-arbitrage. In fact, even if there are scopes for arbitrage opportunities, price adjustment will eliminate them eventually. Essential to the non-existence of arbitrage opportunities in our set up is risk-neutral valuation. According to risk-neutral valuation, the current price of a financial asset equals the expected future price of the asset discounted at the risk-free rate of interest. The central idea underlying risk-neutral valuation parallels the idea implicit in the certainty equivalent. In the certainty equivalent method a risky variable is replaced by one that can be obtained with certainty. The time periods considered in the framework for risk-neutral valuation are discrete.