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A)	promote pricing efficiency.

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

C)	produce riskless profits.

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.

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

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

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

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.

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

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.

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)	There is no free money.

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

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.

A)	provide an opportunity for investors to make a profit.

B)	be low enough for most investors to afford.

C)	provide no opportunity for arbitrage.

Since any observed pricing errors will be instantaneously corrected by the first person to observe them, any quoted price must be free of all known errors. This is the basis behind the text’s no-arbitrage principle, which states that any rational price for a financial instrument must exclude arbitrage opportunities. The no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial markets. This means that markets and prices are efficient. That is, all relevant information is impounded in the asset’s price. With arbitrage and efficient markets, you can create the option and futures pricing models presented in the text.

Which of the following is least likely one of the conditions that must be met for a trade to be considered an arbitrage?

A)	There is no risk.

B)	There are no commissions.

C)	There is no initial investment.

In order to be considered arbitrage there must be no risk in the trade.

It doesn’t matter if commissions are paid as long as the amount of the price discrepancy is enough to offset the amount paid in commissions.

In order to be considered arbitrage there must be no initial investment of one’s own capital. One must finance any cash outlay through borrowing.

A)	Engaging in arbitrage requires a large amount of capital for the investment.

B)	When an opportunity exists to profit from arbitrage, it usually lasts for several trading days.

C)	Pricing errors in securities are instantaneously corrected by the first arbitrageur to recognize them.

Arbitrage is the opportunity to trade in identical assets that are momentarily selling for different prices. Arbitrageurs act quickly to make a riskless profit, causing the price discrepancy to be instantaneously corrected. No capital is required, because opposite trades are made simultaneously.

Which of the following relationships between arbitrage and market efficiency is least accurate?

A)	The concept of rationally priced financial instruments preventing arbitrage opportunities is the basis behind the no-arbitrage principle.

B)	Investors acting on arbitrage opportunities help keep markets efficient.

C)	Market efficiency refers to the low cost of trading derivatives because of the lower expense to traders.

Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer to the cost of trading. One necessary criterion for market efficiency is rapid adjustment of market values to new information. Arbitrage, trading on a price difference between identical assets, causes changes in demand for and supply of the assets that tends to eliminate the pricing difference.