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The Third Fundamental Theorem Of Asset Pricing

Author

Listed:
  • ROBERT JARROW

    () (Johnson Graduate School of Management, Cornell University, Ithaca, NY, 14853, USA;
    Kamakura Corporation, USA)

Abstract

The importance of market efficiency to derivative pricing is not well understood. The purpose of this paper is to explain this connection using the third fundamental theorem of asset pricing. The third fundamental theorem of asset pricing characterizes the conditions under which an equivalent martingale probability measure exists in an economy. Noting that the existence of an equivalent martingale probability measure is both necessary and sufficient for the market being informationally efficient, we prove that in a complete market, the market being efficient is both necessary and sufficient for the validity of the risk neutral valuation methodology.

Suggested Citation

  • Robert Jarrow, 2012. "The Third Fundamental Theorem Of Asset Pricing," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 7(02), pages 1-11.
  • Handle: RePEc:wsi:afexxx:v:07:y:2012:i:02:n:s2010495212500078
    DOI: 10.1142/S2010495212500078
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    Citations

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    Cited by:

    1. Moawia Alghalith & Xu Guo & Wing-Keung Wong & Lixing Zhu, 2016. "A General Optimal Investment Model In The Presence Of Background Risk," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 11(01), pages 1-8, March.
    2. Gabriel Frahm, 2016. "Pricing And Valuation Under The Real-World Measure," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(01), pages 1-39, February.

    More about this item

    Keywords

    No arbitrage; completeness; no dominance; economic equilibrium; market efficiency; martingale measures; local martingales; G12; G13; G14;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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