Answer to Chapter 1 Introduction to Derivatives & Risk Management, Chance, Brooks.

1565 Words Jan 30th, 2012 7 Pages


1. (Market Efficiency and Theoretical Fair Value) An efficient market is one in which prices reflect the true economic values of the assets trading therein. In efficient markets, no one can earn returns that are more than commensurate with the level of risk. Efficient markets are characterized by low transaction costs and by the rapid rate at which new information is incorporated into prices.

2. (Arbitrage and the Law of One Price) Arbitrage is a type of investment transaction that seeks to profit when identical goods are priced differently. Buying an item at one price and immediately selling it at another is a type of arbitrage. Because of the combined activities of
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Gamblers simply accept risk without there being a concomitant reduction in someone else's risk.

8. (Misuses of Derivatives) Derivatives can be misused by speculating when one should be hedging, by not having acquired the requisite knowledge to use them properly by acting irresponsibly when using derivatives such as by being overly confident of one’s ability to forecast the direction of the market.

9. (The Role of Derivative Markets) The existence of derivative markets in the United States economy and indeed throughout most modern countries of the world undoubtedly leads to a much higher degree of market efficiency. Derivatives facilitate the activities of individual arbitrageurs so that unequal prices of identical goods are arbitraged until they are equal. Because of the large number of arbitrageurs, this is a quick and efficient process. Arbitrage on this large a scale makes markets less capable of being manipulated, less costly to trade in, and therefore more attractive to investors. (The opportunity to hedge also makes the markets more attractive to investors in managing risk.) This is not to say that an economy without derivative markets would be inefficient, but it would not have the advantage of this arbitrage on a large scale.

It is important to note that the derivative markets do not necessarily make the U.S. or world economy any larger or wealthier. The basic wealth, expected returns, and risks of the economy would be

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