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An arbitrage is an allowed self-financing portfolio with zero initial wealth, nonnegative terminal portfolio wealth almost surely under the physical probability measure $P$, and strictly positive terminal wealth with positive probability. In a finite model where every state has positive probability, nonnegativity means no loss in any state. Positive expected return alone does not establish arbitrage: losses may still occur.

For the binomial market example, suppose the European call option sells for 13 while its replicating portfolio costs $250/21$. Sell the call, buy its replicating portfolio, and lend the surplus $13-250/21=23/21$ in the bank account. The initial net cost is zero. At maturity the call obligation and portfolio cancel in either state, leaving $(21/20)(23/21)=23/20$. A price below $250/21$ permits the reversed construction, using short selling and borrowing. This is the law of one price made operational; the assumed trading permissions are essential.

Arbitrage pricing theory relates expected returns to systematic factor loadings and their risk premiums. With idiosyncratic noise, a diversification or asymptotic argument needs additional assumptions. With no idiosyncratic noise and spanned factors, the formula is an exact consequence of law of one price: portfolios matching factor exposures can differ only by a constant payoff, which absence of arbitrage forces to be zero.

The law of one price requires traded assets or portfolios with the same terminal payoff to have the same earlier price. In a model where every discounted traded price is a true martingale under a common equivalent measure, it follows by taking the conditional expectation of that terminal payoff. With only local martingale prices and a lower-bound restriction on admissible trading strategies, it can fail: the seemingly profitable short position may have unbounded possible losses before maturity.

Mathematical finance uses probability theory, linear algebra and mathematical optimization to study financial markets, portfolio decisions and contingent claim prices. One question asks which portfolio best serves a specified objective; another asks what price a contingent claim must have to exclude arbitrage. The latter can have an exact answer even when future stock prices are uncertain.

The central idea is claim replication: construct a self-financing portfolio delivering the same financial payoff as a contract in every possible state. The law of one price then identifies the contract's price with the portfolio's initial cost. The binomial market makes this beautiful connection between uncertainty and linear algebra visible using just two equations. Risk-neutral pricing expresses the same cost as a discounted expectation.

The one-step example below fixes today's stock price at 100, terminal prices at 120 or 80, and the bank account's gross growth factor at 1.05. A European call option with strike price 100 pays 20 or zero. Its replicating portfolio in a binomial market costs $250/21$, independently of the physical up probability, provided both states remain possible. These are conclusions within the specified financial market model.

Use unrestricted long and short portfolios, as required by the usual arbitrage pricing theory argument. A vector $v\in {\mathbb{R}}^n$ of initial monetary positions with $1^{T}v=0$ costs zero. Its terminal financial payoff, in the exact one-factor model, isIf also $v^{T}b=0$, the financial payoff is the constant $v^{T}a$. A nonzero value would be an arbitrage after choosing the sign of $v$. Absence of arbitrage thus says that $a$ annihilates $\ker [1b{]}^T$. By finite-dimensional linear algebra,Write $a={\lambda }_{0}1+\kappa b$. Taking expectations, assuming the factor has finite mean, provesThis is exact factor pricing without a traded risk-free asset. The PDF prints an asset-indexed ${\lambda }_i$; the stronger valid result has the same ${\lambda }_1$ for every asset, so it also satisfies the printed relation by taking all its ${\lambda }_i$ equal. If every loading is equal, the spanning vectors are dependent and the coefficients need not be unique. For a nondegenerate factor and a zero-exposure unit-cost portfolio, ${\lambda }_0$ is that portfolio's certain return; if a risk-free asset is explicitly traded, law of one price makes it the risk-free asset's return. No equilibrium preferences are needed for this argument.

Assume a frictionless market with no taxes or transaction costs, unrestricted short selling and borrowing/lending at the same constant rate $r$, continuous trading, and absence of arbitrage. The non-dividend-paying stock has geometric Brownian motion dynamics $dS=\mu Sdt+\sigma SdW$ with constant $\sigma >0$, and the bank account satisfies $dB=rBdt$. A contingent claim with no interim cash flows has sufficiently regular value $f(t,S)$, meaning $f\in C^{1,2}$ before maturity; terminal financial payoff kinks can be handled by the smooth value for earlier times. Trading strategies are adapted, self-financing portfolios, and admissible trading strategies so that doubling strategies are excluded.

The Itô formula givesChoose $\Delta =f_S$ shares and put the remaining value $f-S{f}_S$ in the bank account. Its self-financing gain isMatching the contingent claim's gain to this replicating gain cancels the random increment and equates the drifts:This is the Black-Scholes equation. The argument uses the self-financing gain $\Delta dS$, not a product differential that incorrectly treats a changing $\Delta$ as free cash. Rebalancing purchases are financed from the bank account. Conversely, a smooth solution with suitable growth and boundary conditions defines a delta hedge whose value replicates the contingent claim; law of one price identifies this value with the contingent claim price. Here $S$ is the current stock price, $t$ is time, $\sigma$ is proportional volatility, $r$ is the risk-free rate, and $f$ is the contingent claim price. The physical expected return $\mu$ cancels because exposure to price risk has been hedged.

For strike $K>0$ and maturity $T$, a European call option and a European put option have boundary conditionsThe Black-Scholes equation is solved backward from these conditions. At zero stock price, the zero state is absorbing in geometric Brownian motion, soAt the other boundary, with $\tau =T-t>0$,These conditions and a suitable growth bound select the financial solution and provide boundary data for numerical truncations. In the constant-coefficient model, under the risk-neutral measure,For $d_1=[\log (S/K)+(r+{\sigma }^2/2)\tau ]/(\sigma \sqrt{\tau })$ and $d_2=d_1-\sigma \sqrt{\tau }$, the exercise event is $Z>-d_2$. Completing the square in $e^{\sigma \sqrt{\tau }Z}$ times the normal density gives the truncated first moment and hencewhere $\Phi$ is the standard normal cumulative distribution function. These are the Black-Scholes formula values and satisfy the specified terminal and boundary conditions.

Put-call parity is the relationA call minus a put has terminal financial payoff $S_T-K$. A portfolio of one share minus a zero-coupon bond paying $K$ has the same financial payoff, so absence of arbitrage and law of one price equate their current values. The formula here assumes the same strike and maturity and no dividends; known dividends modify the stock-side value.

For European options with the same strike and maturity, the terminal payoff identity isThus long the call and short the put has the same terminal payoff as one stock less $X$ units of the maturity-$T$ zero-coupon bond. With no dividends, the stock strategy has no intervening payments. The law of one price gives put-call parity:Equivalently the two nonnegative terminal-payoff portfolios, call plus strike bond and put plus stock, agree in every state. The parity proof does not require lognormal stock prices or positive interest.

For American options the exercise times can differ, so equality of their maturity payoffs is not an identity between their full rights. Under the nonnegative-interest, non-dividend assumptions of part (a), $C_A=C_E$ while $P_A=P_E+{\Pi }_P$ with early-exercise premium ${\Pi }_P\ge 0$. Hencewhich generally differs from European parity. For a concrete limiting state, if the stock is zero and remains zero and interest is positive, then $C_A=C_E=0$, $P_A=X$ and $P_E=XB(t,T)<X$. European parity is not a general American-option equality. It holds in a particular case only when the relevant early-exercise premiums cancel, or both vanish.

The two binary terminal payoffs are complementary:in every state, including $S_T=X$. Long one of each is therefore exactly a unit zero-coupon bond. The law of one price gives digital put-call parity:With deterministic interest, the two separate values are $B(t,T)Q(S_T\ge X\mid {\mathcal{F}}_t)$ and $B(t,T)Q(S_T<X\mid {\mathcal{F}}_t)$. There is no need to assume a continuous terminal price distribution: the strict inequality for the put and weak inequality for the call allocate any atom at the strike exactly once.

On a fixed finite horizon, a self-financing strategy consists of predictable stock holdings $h^i$, integrable against the price processes, and a bank account holding $h^0$. Its wealth and gains satisfyAn admissible trading strategy has discounted wealth $X_t/B_t$ bounded below by a deterministic constant throughout the horizon. With the bounded short rate in this part, an undiscounted deterministic lower bound is equivalent after adjusting the constant. An arbitrage is an admissible zero-initial-cost strategy with $X_T\ge 0$ almost surely and $\mathbb{P}(X_T>0)>0$.

Put $1=(1,\dots ,1{)}^{\top }$ and define the market price of riskThe bounded coefficients and bounded inverse make $\lambda$ bounded. Define the stochastic exponentialThe Novikov condition states that $\mathbb{E}\exp (\frac{1}{2}{\int }_0^T\Vert {\lambda }_s{\Vert }^{2}ds)<\infty$ makes this exponential a true martingale with expectation one. Boundedness verifies the condition. Therefore $dQ=L_{T}dP$ defines an equivalent probability measure. The Girsanov theorem states thatis a $d$-dimensional Brownian motion under $Q$. Substituting into the asset equations givesThus $Q$ is an equivalent local martingale measure. The sufficient direction of the fundamental theorem of asset pricing says that such a measure excludes arbitrage among admissible self-financing strategies. Here the reason can be seen directly: $X/B$ is a local martingale under $Q$, and its lower bound makes it a supermartingale. Consequently $X_0=0$ implies ${\mathbb{E}}_Q[X_T/B_T]\le 0$, incompatible with the nonnegative terminal payoff of an arbitrage. Therefore the bounded-inverse market has no arbitrage.

For the requested law of one price counterexample, take a broader continuous-time local-martingale model on $[0,T]$. Let $X$ be a Brownian motion, let $\tau =\inf \{u\ge 0:X_u=-1\}$, and set $q(t)=t/(T-t)$ for $t<T$. DefineThe given hitting-time fact gives $\tau <\infty$ almost surely. The corresponding physical hitting time is $T\tau /(1+\tau )<T$, so $S$ reaches one and then stays one. In particular it is continuous at maturity and $S_t\ge 1$.

For a rigorous closed-horizon localization, stop additionally when $S$ hits $n+2$, or at $T$ if it never does. The stopped process is Brownian motion stopped on first exiting $(-1,n)$ and subjected to the deterministic clock; it is a bounded martingale, including at $T$. The stopping times increase to $T$, since every Brownian path on the finite random interval $[0,\tau ]$ has a finite maximum. Thus $S$ is a positive local martingale on the whole horizon. With the time-changed Brownian filtration, the original probability measure is an equivalent local martingale measure. The admissible-wealth supermartingale argument above proves no admissible arbitrage.

Nevertheless $S_T=B_T=1$ while $S_0=2\ne B_0=1$, so the law of one price fails. Shorting one share and buying two units of cash has zero initial cost and terminal gain one, but its wealth is $2-S_t$. It has no deterministic lower bound: for every $n$, the probability of Brownian motion hitting $n$ before $-1$ is $1/(n+1)>0$, obtained by optional stopping of the bounded stopped Brownian motion. That apparently profitable strategy is therefore inadmissible. The counterexample deliberately uses a strict local martingale; the bounded-coefficient class in the first part has true discounted asset martingales and does satisfy the law of one price.

Put-call parity fixes the price difference between a European call option and a European put option on the same underlying stock, with the same strike price $K$ and expiry $T$. Assume no dividends or other payments from the stock before or at expiry, a known constant continuously compounded interest rate $r$, and a frictionless market. Borrowing and lending are available at that same interest rate; short selling of the stock, European call option, European put option, and zero-coupon bond is permitted. Settlement is certain, and the buy-and-hold portfolios below may be held until $T$ without interim funding restrictions or forced liquidation. These assumptions exclude transaction costs, taxes, borrowing fees, and execution or settlement risks from the arbitrage argument.

At expiry, the two positive parts cancel their corners:Thus a European call option and a short European put option together have the same terminal financial payoff as one stock share with a debt of $K$. A particularly readable claim replication uses two portfolios with nonnegative terminal amounts: portfolio A holds one European call option and a risk-free zero-coupon bond paying $K$ at $T$; portfolio B holds one European put option and one stock share. The zero-coupon bond costs $K{e}^{-rT}$ today, since the discount factor is $e^{-rT}$. There are no intermediate cash flows. For every terminal stock price,For the strike price $K=100$, even the following very different outcomes leave the two portfolios equal:

The law of one price forces $A_0=B_0$ in this setting: otherwise buy the cheaper portfolio and sell the more expensive portfolio using short selling. Their terminal obligations cancel in every scenario, while the initial price difference can grow in the bank account. Hence absence of arbitrage givesWith a constant per-period interest rate $i$ over $N$ discrete periods, the same reasoning gives $C_0-P_0=S_0-K(1+i{)}^{-N}$. This is a different compounding convention; $i$ is not the continuously compounded interest rate $r$.

For an illustrative stock price $S_0=100$, strike price $K=100$, expiry one year away, interest rate $r=0.05$ per year, and given European call option price $C_0=10$, put-call parity requiresBoth portfolios therefore cost approximately $105.12294245$. The inputs specify no stock price dynamics: $C_0=10$ is supplied for illustration, not calculated from the Black-Scholes model. Put-call parity determines the European put option price conditional on that European call option price; it does not determine both prices by itself. At zero interest rate, the same $S_0=K=100$ and $C_0=10$ give the exact result $P_0=10$.

To compute both directions of arbitrage, keep all the preceding inputs except the quoted European put option price. If it is $6$, portfolio B costs $106$ while portfolio A costs $105.12294245$. Buy A, sell B, and place the initial surplus $6-(10+100e^{-0.05}-100)\approx 0.87705755$ in the bank account. At expiry, A and the obligations from selling B cancel exactly, leaving $96e^{0.05}-100\approx 0.92202525$ in every scenario. If the European put option instead costs $4$, buy B for $104$ and sell A for $105.12294245$; the initial surplus is approximately $1.12294245$, growing to $100-94e^{0.05}\approx 1.18051694$. Both constructions start with zero external capital. They are model calculations under the stated frictionless market assumptions.

The beauty of put-call parity is that uncertain individual financial payoffs produce an exact relation between today's prices. No forecast of the terminal stock price and no probability distribution are needed. It provides a consistency check and lets claim replication exchange one contract for a combination of others. Dividends introduce extra cash flows, and American put options can be exercised early, so the displayed European equality cannot simply be transferred to those contracts. K. Foster's ^[ref] explain the matching portfolios; Jun Pan's ^[ref] discuss put-call parity and its dividend adjustment.

An original modern research source is Hans R. Stoll's ^[ref], The Journal of Finance 24(5), 801-824 (December 1969). Stoll studied the relation between contract prices and tested it against market data; this was a relation between prices rather than a formula fixing each price individually. Robert C. Merton's ^[ref], 28(1), 183-184, highlighted the importance of excluding premature exercise for an exact arbitrage equality. This distinction explains why the exercise assumption belongs in the statement of put-call parity.