clearlycanadian

Which of the following is the best interpretation of the no-arbitrage principle?

A) There is no way you can find an opportunity to make a profit.

B) The information flow is quick in the financial market.

C) There is no free money.

---

An arbitrage opportunity is the chance to make a riskless profit with no investment.
In essence, finding an arbitrage opportunity is like finding free money.
As you recall, in arbitrage, you observe two identical assets with different prices.
Your immediate response should be to buy the cheaper one and sell the expensive one short.
You can then deliver the cheap one to cover your short position.
Once you take the initial arbitrage position, your arbitrage profit is locked in.
The no-investment statement referenced in the text refers to the assumption that when you short the expensive asset, you will be given access to the cash created by the short sale.
With this cash, you now have the money to buy the cheaper asset.
The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves.

clearlycanadian

The process that ensures that two securities positions with identical future payoffs, regardless of future events, will have the same price is called:

A) arbitrage.

B) exchange parity.

C) the law of one price.

---

If two securities have identical payoffs regardless of events, the process of arbitrage will move prices toward equality. Arbitrageurs will buy the lower priced position and sell the higher priced position, for an immediate profit without any future liability. The law of one price (for securities with identical payoffs) is not a process; it is ‘enforced’ by arbitrage.

clearlycanadian

Which of the following is an example of an arbitrage opportunity?

A) A put option on a share of stock has the same price as a call option on an identical share.

B) A portfolio of two securities that will produce a certain return that is greater than the risk-free rate of interest.

C) A stock with the same price as another has a higher rate of return.

---

An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless rate to purchase the position will produce a certain future amount greater than the amount required to repay the loan.

clearlycanadian

The process of arbitrage does all of the following EXCEPT:

A) promote pricing efficiency.

B) produce riskless profits.

C) insure that risk-adjusted expected returns are equal.

---

Arbitrage does not insure that the risk-adjusted expected returns to two risky assets will be equal. Arbitrage is based on risk-free portfolios and promotes efficient pricing of assets. When an arbitrage opportunity is presented by a mispricing of assets, the increased supply of the ‘overpriced’ asset and the increased demand for the ‘underpriced’ asset by arbitrageurs, will move the prices toward equality and act to correct the mispricing.

clearlycanadian

A standardized and exchange-traded agreement to buy or sell a particular asset on a specific date is best described as a:

A) forward contract.

B) futures contract.

C) swap.

---

Futures contracts are standardized forward contracts that trade on organized exchanges. Other types of forward contracts, as well as swaps, are custom instruments that are generally not exchange-traded.

clearlycanadian

An agreement that gives the holder the right, but not the obligation, to sell an asset at a specified price on a specific future date is a:

A) call option.

B) put option.

C) swap.

---

A put option gives the holder the right to sell an asset at a specified price on a specific future date. A call option gives the holder the right to buy an asset at a specified price on a specific future date. A swap is an obligation to both parties.