E EXPLAIN ARBITRAGE AND THE ROLE IT PLAYS IN DETERMINING PRICES AND PROMOTING MARKET EFFICIENCY;

Question 1

Arbitrage

Answer 1

Arb involves taking a positions in two markets that results in a riskless profit
with no net investment.
• Law of One Price.
 Two investments with identical cash flow must trade at the same price
• Arb activity keeps prices in line with their no-arb value.
 If a derivative contract is overvalued, arbitrageurs will sell it and buy the
underlying
 If a derivative contract is undervalued, arbitrageurs will buy it and sell
the underlying

Does not tell the true fundamental value as it is not an absolute valuation methodology. Its relative, tells us relative price of one asset or derivative to another asset or derivative.

“Arbitrage is only a relative pricing method. It prices the two stocks in relation to each other but does not price either on the basis of its own fundamentals.”

Question 2

Value asks,

Answer 2

What is something worth?

Value is the PV of FCF’s

“The underlying takes its value from the discounted present value of the expected future cash flows it offers, with discounting done at a rate reflecting the investor’s risk tolerance.”

Question 3

Hedge Portfolio

Answer 3

A hypothetical combo of derivs and underlyings that eliminate risk in order to earn the risk free rate.

Question 4

Principle of Derivative Valuation

Answer 4

Storability. Equities are perpetual. Bonds are stored until maturity.

Question 5

Foundation of the Principle

Answer 5

Law of One Price: Well functioning markets, low transaction costs and free flow of info means prices get pushed to one price and arbitrage isn’t possible.`

Question 6

Summary

Answer 6

“the forces of arbitrage in financial markets assure us that the same asset cannot sell for different prices, nor can two equivalent combinations of assets that produce the same results sell for different prices. Realistically, some arbitrage oppor- tunities can exist on a temporary basis, but they will be quickly exploited, bringing relative prices back in line with each other. Other apparent arbitrage opportunities will be too small to warrant exploiting.”