arbitrage

Question 1

theoretical arbitrage

Answer 1

trading strategy that requires no initial investment, has no negative cashflow at any time, has positive cashflow at at least one time

Question 2

when is arbritrage possible

Answer 2

when there is mispricing and arbitrage forces prices to converge, buy low sell high, rewuires long and short positions

Question 3

dominance argument

Answer 3

numerous small investors marginally adjust their holdings depending on their degree of risk aversion

Question 4

arbitrage argument

Answer 4

a few large investors try to take as big a position as possible and the degree of risk aversion doesn’t matter

Question 5

practical arbitrage

Answer 5

trading strategy that is expected to make profit in expectation, each arbitrageur wants to invest an infinite amount of money in the strategy, care is needed with longer term strategies

Question 6

true arbitrage

Answer 6

doesn’t/cannot exist, if existed, people would take advantage and prices would adjust to take advantage of them. the no-arbitrage condition is a cornerstone of asset pricing

Question 7

ARBITRAGE OPPORTUNITIES

Answer 7

Rare, ephemeral, subtle, complex, risk of interim adverse price movements, eroded by frictions

Question 8

bid-ask spread

Answer 8

mid = bid + ask/2 = used to value holdings, is the transaction cost investors must pay in order to trade

Question 9

determining bid - ask spread

Answer 9

depends on liquidity
want sufficient number of buyers and sellers of a security - ensures trading at any time at the current market price

Question 10

illiquid markerts

Answer 10

market prices are no longer a measure of value leading to loss of information

Question 11

market makers care about..

Answer 11

liquidity risk, wider spread required to handle low trading volume assets
volatility risk - wider safety net needed (wider spread0
internal guidelines on inventory
reputation
adverse selection - risk of an informed counterpart (why is the person getting rid of a product_

Question 12

market order

Answer 12

executed immediately at current marketprice complication - what if order is larger than maximum size for the price, pro - quick, con - may get worse price

Question 13

limit order

Answer 13

trade at best price available pro - get good price con may not execute

Question 14

stop order

Answer 14

triggered when price reaches a specific limit price pro: limit losses in trader’s absence, con could be worst time to trade

Question 15

fill or kill

Answer 15

expires immediately following submission, no partial trading

Question 16

implications of no arbitrage - LOOP

Answer 16

law of one price - if two securities have same payoff, have same price

Question 17

implications of no arbitrage - portfolio replication

Answer 17

if a portfolio has the same payoff as a security it must have the same price

Question 18

dynamic hedging strategy

Answer 18

if self-financing strategy has the same payoff as a security it must have the same price.

Question 19

frictions

Answer 19

transaction costs - hence in the presence of trans costs there cannot be deterministic price
no arbitrage price range

Question 20

NPV (net PV) of trading securities

Answer 20

trading security as investment decision, if a normal (no arbitrage) market then no-arb price of a security = PV
NPV (buying) = PV - price = 0
NPV (selling) = price - PV = 0

Question 21

zero-sum trading game

Answer 21

if in a competitive market NPV <0 or NPV >0, one counterparty benefits, one loses, there may be no trade. FINANCIAL TRANSACTIONS SHOULD NOT BE SOURCES OF VALUE but should serve to adjust the timing and risks of the cashflows to suit the needs of firms and investors.

Question 22

FX arbitrage

Answer 22

the strategy of exploiting price disparity in the forex markets

Question 23

Equities arbitrage

Answer 23

Practice of buying and selling shares of a particular stock to exploit tiny differences in their prices across different markets.

Question 24

adverse selection

Answer 24

problem arising under asymmetric information - when one counterparty has more information than the other the other is right to be worried that it may be taken advantage of

Question 25

carry trade

Answer 25

borrowing at low interest rate and investing in an asset providing higher RoR. Risks - sharp decline in price of invested assets
implicit exchange rate,