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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)
Market efficiency refers to the low cost of trading derivatives because of the lower expense to traders.
C)
Investors acting on arbitrage opportunities help keep markets efficient.



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.

TOP

One reason that criticism has been leveled at derivatives and derivatives markets is that:
A)
derivatives have too much default risk.
B)
derivatives expire.
C)
they are complex instruments and sometimes hard to understand.



The fact that derivative securities are sometimes complex and often hard for non-financial commentators to understand has led to criticism of derivatives and derivative markets.

TOP

All of the following are benefits of derivatives markets EXCEPT:
A)
transactions costs are usually smaller in derivatives markets, than for similar trades in the underlying asset.
B)
derivatives markets help keep interest rates down.
C)
derivatives allow the shifting of risk to those who can most efficiently bear it.



The existence of derivatives markets does not affect the level of interest rates. The other statements are true.

TOP

Which of the following is a common criticism of derivatives?
A)
Derivatives are likened to gambling.
B)
Derivatives are too illiquid.
C)
Fees for derivatives transactions are relatively high.



Derivatives are often likened to gambling by those unfamiliar with the benefits of options markets and how derivatives are used.

TOP

Which of the following statements about arbitrage is NOT correct
A)
Arbitrage can cause markets to be less efficient.
B)
No investment is required when engaging in arbitrage.
C)
If an arbitrage opportunity exists, making a profit without risk is possible.



Arbitrage is defined as the existence of riskless profit without investment and involves selling an asset and simultaneously buying the same asset for a lower price. Since the trades cancel each other, no investment is required. Because it is done simultaneously, a profit is guaranteed, making the transaction risk free. Arbitrage actually helps make markets more efficient because price discrepancies are immediately eradicated by the actions of arbitrageurs.

TOP

Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT:
A)
engage in high risk speculation.
B)
increase market efficiency through the use of arbitrage.
C)
narrow the amount of trading opportunities to a more manageable range.



Financial derivatives increase the opportunities to either speculate or hedge on the value of underlying assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders.

TOP

MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the earnings announcement the value of MBT common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than expected news. This gradual change in the value of the stock is an example of:
A)
speculation.
B)
efficient markets.
C)
inefficient markets.



A critical element of efficient markets is that asset prices respond immediately to any new information that will affect their value. Large numbers of traders responding in similar fashion to the new information will create a temporary imbalance in supply and demand, and this will adjust asset market values.

TOP

Derivatives are often criticized by investors with limited knowledge of complex financial securities. A common criticism of derivatives is that they:
A)
increase investor transactions costs.
B)
can be likened to gambling.
C)
shift risk among market participants.



Derivatives are often likened to gambling due to the high leverage involved in the payoffs. One of the benefits of derivatives is that they reduce transactions costs. Another benefit of derivatives is that they allow risk to be managed and shifted among market participants.

TOP

Which of the following is most accurate regarding derivatives?
A)
Exchange-traded derivatives are created and traded by dealers in a market with no central location.
B)
Derivative values are based on the value of another security, index, or rate.
C)
Derivatives have no default risk.



Derivatives “derive” their value from the value or return of another asset or security. Exchange-traded derivatives are standardized and backed by a clearinghouse. An over-the-counter derivative, such as a forward contract or a swap, exposes the derivative holder to the risk that the counterparty may default.

TOP

Over-the- counter derivatives:
A)
have good liquidity in the over-the-counter (OTC) market.
B)
are backed by the OTC Clearinghouse.
C)
are customized contracts.



OTC derivative contracts (securities) are customized and have poor liquidity. The contract is with a specific counterparty and there is default risk since there is no clearinghouse to guarantee performance.

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