Arbitrage and Law of One Price Quiz

The law of one price relies on the assumption of perfect information and frictionless markets, meaning that all participants have access to the same information and can trade without barriers. This ensures that any price discrepancies for identical assets will be quickly arbitraged away, leading to uniform pricing across different markets.

To profit from the price discrepancy, the arbitrageur should buy gold at the lower price in New York ($1,900/oz) and sell it at the higher price in London ($1,920/oz). This strategy capitalizes on the price difference, allowing the arbitrageur to earn a profit from the transaction.

For pure arbitrage to exist, there must be a risk-free opportunity that guarantees a positive expected return. This means that an investor can exploit price discrepancies without any risk of loss, ensuring a profit regardless of market conditions. Other factors like volatility or investor behavior do not directly create arbitrage opportunities.

Transaction costs and bid-ask spreads establish a no-arbitrage band by ensuring that the costs of executing trades outweigh potential profits from price discrepancies. This means that any price differences between markets fall within a range where arbitrage opportunities are eliminated, as the costs prevent traders from making risk-free profits.

In cash-and-carry arbitrage, the trader aims to exploit price discrepancies between the spot and futures markets. By buying the asset at the lower spot price and selling the futures contract at a higher price, the trader locks in a profit equal to the difference, ensuring a risk-free return on the investment.

The no-arbitrage principle asserts that in an efficient market, the forward price of an asset must reflect the cost of carrying that asset until the future delivery date. This is represented by the spot price multiplied by the growth factor, which accounts for the risk-free rate, ensuring no arbitrage opportunities exist.

Arbitrage involves exploiting price differences in different markets without taking on market risk. It relies on simultaneous buying and selling to lock in profits, ensuring that any potential risk is minimized. Therefore, successful arbitrage can be achieved without exposure to market fluctuations, making the statement false.

In convertible arbitrage, traders exploit the mispricing of the embedded call option in the convertible bond. By shorting the stock and buying the bond, they capitalize on the bond's potential value increase when the stock price rises, indicating that the call option is undervalued compared to the stock's market price.

Market efficiency relies on the law of one price, which states that identical goods should have the same price in different markets when there are no barriers. Frictions, such as transaction costs, regulatory hurdles, or information asymmetry, can impede market access and disrupt price uniformity, leading to inefficiencies and potential arbitrage opportunities.

A statistical arbitrage strategy depends on the assumption that asset prices will revert to their historical relationships. A structural shift in asset correlations disrupts these historical patterns, making it difficult for the strategy to predict price movements accurately. This unpredictability can lead to significant losses, causing the strategy to fail.

Arbitrageurs capitalize on price differences for identical assets in different markets. By buying low in one market and selling high in another, they create pressure that aligns prices across markets. This activity minimizes discrepancies and reinforces the law of one price, ensuring that identical goods have a uniform price in efficient markets.

Arbitrage opportunities arise when a stock is priced differently across exchanges. However, to capitalize on these discrepancies, traders must execute transactions, which involves costs such as fees and time delays. These factors can limit the potential profit from arbitrage, as they reduce the effective gain from buying low on one exchange and selling high on another.