Finance theory treats arbitrage as enforcing equal risk-adjusted returns

Evidence

More generally, beginning with the work of Modigliani and Miller, it was fundamental to finance theory that, in the words of Myron Scholes, “the market will price assets such that the expected rates of return on assets of similar risk are equal.” If the market did not do so, Modigliani, Miller, and their successors reasoned, “investors seeing these profit opportunities would soon arbitrage them away” (Scholes 1972, p. 182). LTCM’s “relative value” arbitrage can be seen as precisely this kind of arbitrage. — Donald MacKenzie, An Engine, Not a Camera, 1003

Categorization

• XREF: Directly connects the performativity thesis to how LTCM enacted the Modigliani-Miller/Scholes pricing arbitrage assumption in practice. — connects to: The arbitrage argument produces the Black-Scholes partial differential equation. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 95; Market arbitrage requires only that investors prefer more wealth to less, not risk preferences — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 180; Warrant prices are bounded by no-arbitrage constraints against stock prices — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 551 (+4 more)

Broader Connections

• Risk-neutral valuation yields the identical option price as arbitrage arguments #expands (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1285
• Constrained arbitrage allows finance-theory models to diverge from actual prices. #qualifies (0.80) — Donald MacKenzie, An Engine, Not a Camera, 1213
• Arbitrage erodes the profitability of exploiting the index inclusion anomaly #exemplifies (0.80) — Donald MacKenzie, An Engine, Not a Camera, 462