Three little arbitrage theorems

Abstract

The authors proved three theorems about the exact solutions of a generalized or interacting Black–Scholes equation that explicitly includes arbitrage bubbles. These arbitrage bubbles can be characterized by an arbitrage number AN. The first theorem states that if AN = 0, then the solution at maturity of the interacting equation is identical to the solution of the free Black–Scholes equation with the same initial interest rate of r. The second theorem states that if AN ≠ 0, then the interacting solution can be expressed in terms of all higher derivatives of the solutions to the free Black–Scholes equation with an initial interest rate of r. The third theorem states that for a given arbitrage number, the interacting solution is a solution to the free Black–Scholes equation but with a variable interest rate of r(τ) = r + (1/τ)AN(τ), where τ = T − t.