Financial Market Theory Thursday, August 30, 2018 Professor Edwin T Burton

The Concept of a Default Free Asset A default free asset always delivers on whatever it promises. The payments that a default free asset promises will be paid without any uncertainty at all. Best example: sovereign debt (sovereign debt is the debt issued by government) In the US, US Treasury securities represent the “default free asset” If we were in Tokyo, JGBs (Japanese Government Bonds) represent the “default free asset” The return of a default free asset is not generally riskless. The value of a default free asset is not necessarily fixed and may change in the market place (example: US 30 Year Treasury Bond) August, 24, 2017

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 August, 24, 2017

“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 August, 24, 2017

Arbitrage If there is a single asset that has two different prices, then an “arbitrage opportunity presents itself An arbitrageur will buy at the lower price and sell at the higher price. The profit will be an “arbitrage profit” Whether or not an arbitrage is possible depends upon asset prices A basic assumption of finance theory is the “No Arbitrage” assumption. This says that prices are such that there is no opportunity for an arbitrage profit In applying this assumption, it is usually taken to be okay for limited arbitrage opportunities to appear that investors take advantage of and that such opportunities disappear quickly by the activities of arbitrageurs or investors