clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.

clearlycanadian

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.