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1.Which of the following is the best interpretation of the no-arbitrage principle?
A. The information flow is quick in the financial market.
B. There is no free money.
C. People can never beat the market.
D. There is no way you can find an opportunity to make a profit.
2.Which of the following assumptions is NOT necessary to derive the APT?
A.There are no arbitrage opportunities available to investors.
B.The factor portfolios are efficient.
C.Investors can create diversified portfolios with no firm-specific risk.
D.A factor model describes asset returns.
3.Parametric notes are fixed income instruments with cash flows:
A. determined by parametric distributions.
B. linked to an external risk event, such as an earthquake.
C. that are triggered by internal risk events, such as fraud.
D. linked to an index of underwriting losses.
Answer:
1.B
An arbitrage opportunity is the chance to make a riskless profit with no investment. In essence, finding an arbitrage opportunity is like finding free money. As you recall, in arbitrage, you observe two identical assets with different prices. Your immediate response should be to buy the cheaper one and sell the expensive one short. You can then deliver the cheap one to cover your short position. Once you take the initial arbitrage position, your arbitrage profit is locked in. The no-investment statement referenced in the text refers to the assumption that when you short the expensive asset, you will be given access to the cash created by the short sale. With this cash, you now have the money to buy the cheaper asset. The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves.
2.B
The APT is an equilibrium model that assumes there are no arbitrage opportunities in equilibrium, that investors can create diversified portfolios, and that a factor model describes asset returns. It does NOT require that factor portfolios (nor, as in the capital asset pricing model [CAPM], the market portfolio) be efficient. In effect, the APT assumes investors simply like more money to less, while the CAPM assumes they care about expected return and standard deviation and invest in efficient portfolios. The APT makes no reference to mean-variance analysis or assumptions about efficient portfolios. This weaker set of assumptions is an advantage of the APT over the CAPM.
3.B
All the bonds described above, except for one, are types of catastrophe bonds. Parametric notes link cash flows to the magnitude of an external risk event, such as hurricane severity in a particular region. Indemnified notes offer the issuing firm debt relief based on internal events, such as a large underwriting loss for an insurance company. Indexed notes provide cash flows related to the value of an independent index, such as a weather index or an insurance underwriting loss index. Bonds with cash flows determined by parametric distributions are quixotic.
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