7.4 Arbitrage, replication, and the Cost of Carry in Pricing Derivatives

Question 1

the law of one price

Answer 1

the no-arbitrage principle

how derivatives are priced

This law is violated if investors have an arbitrage opportunity, which is the chance to a profit without putting any of their own capital at risk.

Question 2

The simplest case of arbitrage is

Answer 2

a single asset selling for different prices simultaneously

Question 3

Other costs of ownership

Answer 3

storage, transportation, insurance, and spoilage

These can be significant when the underlying asset is a physical commodity.

Financial assets typically do not impose any carrying costs beyond the opportunity cost of the risk-free rate.

As with the risk-free rate, an increase in these costs will produce a higher forward price.

Question 4

Benefits of ownership

Answer 4

cash flows, such as dividends from stocks and coupon payments from fixed-income securities.

A non-cash benefit, known as a convenience yield may be observed in prices when economic conditions cause investors to prefer holding the physical underlying

All else equal, greater benefits from owning the underlying will reduce the forward price.

Question 5

Which one of the following is least likely to impact the forward price at initiation?

A
The risk-free rate

B
The investor’s degree of risk aversion

C
The expected benefit of holding the underlying asset

Answer 5

C
The expected benefit of holding the underlying asset

Since the risk-free rate is the same for all investors, any differences between investors’ levels of risk aversion will have no such impact.