LOS d: Explain arbitrage and the role it plays in determining prices and promoting market efficiency.

Q1. The process of arbitrage does all of the following EXCEPT:

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

B)   promote pricing efficiency.

C)   produce riskless profits.

Q2. 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.

Q3. The process that ensures that two securities positions with identical future payoffs, regardless of future events, will have the same price is called:

A)   exchange parity.

B)   arbitrage.

C)   the law of one price.

Q4. 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.

Q5. Any rational quoted price for a financial instrument should:

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.

Q6. 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 is no initial investment.

C)   There are no commissions.

Q7. Which of the following statements about arbitrage opportunities is TRUE?

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

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

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

Q8. 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.

Q9. A 4 percent Treasury bond has 2.5 years to maturity. Spot rates are as follows:

The note is currently selling for $976. Determine the arbitrage profit, if any, that is possible.

A)   $37.63.

B)   $19.22.

C)   $43.22.

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