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Wall Street Profits, Arbitrage, and the Pricing of Stock Options

Finance is sometimes called the study of arbitrage. A finance person defines arbitrage as the presence of a riskless profit. Suppose we can buy IBM stock today from Peter for $100 and immediately sell it to Paul for $105. This would represent a $5 profit with no risk! It is like finding $5 on the sidewalk. Of course, our capital markets are fully aware that equivalent assets should sell for the same price, that riskless assets should earn the riskless interest rate, and that five-dollar bills do not remain on the sidewalk for very long. Investors establish prices such that these conditions prevail and any arbitrage opportunities quickly disappear. Stock option pricing theory provides a fascinating illustration of how arbitrage arguments lead to a remarkable, counterintuitive conclusion, one that led to the 1997 Nobel Prize in Economics : The valueof a stock. option is independent of the expected rate of return on the stock.. Although a derivation of the Black-Scholes option-pricing model is beyond the scope of this article, the intuition behind the model is interesting, especially given the counterintuitive result regarding the importance of expectations about the stock's future.