Narrowing the no-arbitrage bounds

It is shown by example and by analytic argument that the no-arbitrage bounds can be narrowed by ruling out arbitrages between asset markets and stochastic production opportunities. The key analytic construct is the derivative-cost function. The narrowed no-arbitrage bounds can be calculated either as directional derivatives of the derivative-cost function or directly from the derivative-cost function itself. It is shown how some assets lying outside the subspace generated by the basis assets can be priced uniquely using the no-arbitrage prices associated with the derivative-cost function. An extension of the analysis to permit market frictions is briefly discussed. (c) 2007 Elsevier B.V. All fights reserved.