6) Risk and No-Arbitrage

Question 1

What is risk

Answer 1

An investment is risky if its actual return will be different from its expected return

Question 2

What is an Arbitrage Opportunity

Answer 2

A way to make a risk-free profit. An opportunity which yields a positive payoff (in all circumstances) with zero initial investment
Π(S, T) > 0 for all S ∈ [0, ∞).

Question 3

What is the No-Arbitrage Principle

Answer 3

Question 4

What does the No-Arbitrage Principle imply when comparing two financial contracts V and ^V

Answer 4

Question 5

What does the No-Arbitrage Principle imply when comparing two equivalent financial contracts V and ^V

Answer 5

Question 6

What does the No-Arbitrage Principle imply about return on Risk-Free Contracts

Answer 6

Question 7

What is the put-call parity relationship

Answer 7

Question 8

Describe the proof of the put-call parity relationship

Answer 8

Question 9

What are the upper and lower bounds of the call option

Answer 9

Question 10

Describe the proof of the lower bound of a call option

Answer 10

Question 11

What are the upper and lower bounds of the put option

Answer 11

Question 12

How do we show there is an an arbitrage opportunity by using the bounds of an option

Answer 12

If the option does not fit within it’s inequality, buy the side that is too low and sell the side is too high