Glossary — M04: Arbitrage, Replication, and Cost of Carry
Term
Definition
Arbitrage
A transaction that generates a risk-free profit with zero net investment by exploiting pricing discrepancies
Law of one price
The principle that two assets or portfolios with identical future cash flows in all states must have the same current price
Replication
Constructing a portfolio of traded assets that produces the same payoff as a derivative in every future state
No-arbitrage pricing
The method of determining derivative prices by equating the derivative’s value to the cost of its replicating portfolio, ensuring no arbitrage is possible
Replicating portfolio
A combination of the underlying asset and risk-free borrowing/lending that exactly reproduces a derivative’s payoff
Cost of carry
The total cost of holding the underlying asset until the derivative’s expiration, including financing costs, storage, and insurance
Net cost of carry
Carrying costs minus benefits of holding: Net Cost of Carry=Costs−Benefits (income + convenience yield)
Convenience yield
The non-monetary benefit of physically holding a commodity (e.g., ensuring supply continuity), which reduces the forward price
Contango
Market condition where the forward/futures price exceeds the spot price (net cost of carry > 0)
Backwardation
Market condition where the forward/futures price is below the spot price (net cost of carry < 0, often due to high convenience yield)