Arbitrage-Free Models are mathematical frameworks for pricing financial instruments, especially derivatives in crypto markets, designed to prevent the theoretical existence of riskless profit opportunities through simultaneous trades. Their core function is to establish internally consistent and fair valuations.
Mechanism
These models maintain internal consistency by adhering to fundamental economic principles, such as the efficient market hypothesis, which posits no free profit. They calibrate to observed market prices of highly liquid instruments, ensuring that theoretical valuations align with real-world conditions and preventing exploitable price discrepancies.
Methodology
Developing arbitrage-free models requires complex stochastic calculus and numerical methods, commonly applied to option valuation or yield curve construction within the crypto trading space. This systematic construction provides a reliable basis for accurate pricing, effective hedging, and robust risk management, thereby fostering market stability for institutional participants.
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