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Derivatives【Reading 60】Sample

Which of the following statements regarding exchange-traded derivatives is NOT correct? Exchange-traded derivatives:
A)
often trade in a physical location.
B)
are illiquid.
C)
are standardized contracts.



Derivatives that trade on exchanges have good liquidity in most cases. They have the other characteristics listed.

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.

TOP

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.

TOP

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.

TOP

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.

TOP

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.

TOP

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.

TOP

Any rational quoted price for a financial instrument should:
A)
provide no opportunity for arbitrage.
B)
provide an opportunity for investors to make a profit.
C)
be low enough for most investors to afford.


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.

TOP

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 are no commissions.
B)
There is no risk.
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.

TOP

Which of the following statements about arbitrage opportunities is CORRECT?
A)
Engaging in arbitrage requires a large amount of capital for the investment.
B)
Pricing errors in securities are instantaneously corrected by the first arbitrageur to recognize them.
C)
When an opportunity exists to profit from arbitrage, it usually lasts for several trading days.



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.

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