5. Arbitrage and Valuation of Different Contracts

In this chapter, I first derive the Arbitrage Theorem, and use the theorem to show that, in a complete market with no transaction costs and no arbitrage, all securities or assets are derivatives for each other, and they are dependent on each other. It also shows a capital structure irrelevancy proposition: changes in firms’ debt-equity ratios will not affect equityholders’ wealth (welfare), and equityholders’ preferences toward risk (or variance) are irrelevant. When the firm moves from a more certain project to a more uncertain one, the time-0 price of equity will increase, but the time-0 prices of fixed-income assets will decrease. Different labor contractual arrangements will not affect the time-0 price of labor input. When the firm moves from a more certain project to a more uncertain one, the time-0 price of labor input will increase if it is under the share or the mixed contract.