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Unformatted text preview: 1 Answers to Questions and Problems 1. If an arbitrage opportunity did exist in a market, how would traders react? Would the arbitrage opportunity persist? If not, what factors would cause the arbitrage opportunity to disappear? Traders are motivated by profit opportunities, and an arbitrage opportunity represents the chance for risk- less profit without investment. Therefore, traders would react to an arbitrage opportunity by trading to exploit the opportunity. They would buy the relatively underpriced asset and sell the relatively overpriced asset. The arbitrage opportunity would disappear, because the presence of the arbitrage opportunity would create excess demand for the underpriced asset and excess supply of the overpriced asset. The arbitrageurs would continue their trading until the arbitrage opportunity disappeared. 2. Explain why it is reasonable to think that prices in a financial market will generally be free of arbitrage opportunities. Generally arbitrage opportunities will not be available in financial markets because well-informed and intel- ligent traders are constantly on the lookout for such chances. As soon as an arbitrage opportunity appears, traders trade to take advantage of the opportunity, causing the mispricing to be corrected. 3. Explain the difference between a derivative instrument and a financial derivative. A derivative is a financial instrument or security whose payoffs depend on any underlying asset. A financial derivative is a financial instrument or security whose payoffs depend on an underlying financial instrument or security. 4. What is the essential feature of a forward contract that makes a futures contract a type of forward contract? A forward contract always involves the contracting at one moment in time with the performance under the contract taking place at a later date. Thus, futures represent a kind of forward contract under this definition. 5. Explain why the purchaser of an option has rights and the seller of an option has obligations. The purchaser of an option makes a payment that is the consideration given to acquire certain rights. By contrast, the seller of an option receives payment at the time of sale and undertakes certain obligations in return for that payment. 6. In a futures contract, explain the rights and obligations of the buyer or seller. How does this compare with an option contract? In a futures contract, both the buyer and the seller have both obligations and rights. The buyer of a futures contract promises to make payment and take delivery at a future date, while the seller of a futures contract 1 Introduction promises to make delivery and receive payment at a future date. This contrasts with the option market in which the buyer has only rights and the seller has only obligations following the original transaction....
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- Spring '08