What is the role of arbitrage in the derivatives area?
All pricing of derivatives is done by arbitrage, and by arbitrage alone. In other words, basic economics dictates a relationship between the price of the spot and the price of a futures. If this relationship is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price reverts back to its economic value. In this sense, arbitrage is basic to pricing of derivatives. Without arbitrage, there would be no market efficiency in the derivatives market: prices would stray away from fair value all the time. Indeed, a basic fact about derivatives is that the market efficiency of the derivatives market is inversely proportional to the transactions costs faced by arbitrageurs in that market. When arbitrage is fluent and effective, market efficiency is obtained, which improves the attractiveness of the derivatives from the viewpoint of users such as hedgers or speculators.
