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CFA Level I · CFA Level I Exam · Derivative Benefits, Risks, and Issuer and Investor Uses

An analyst observes that a derivative contract and a replicating portfolio of the underlying and a risk-free asset have different prices. Which statement about the market's response is most likely correct?

Arbitrageurs would buy the cheaper position and sell the more expensive one, earning riskless profit until prices converge. This activity ties derivative prices to the underlying and improves market efficiency. Derivatives are not priced independently of the underlying, and the gap would not persist in liquid markets.

  1. ATraders buy the cheaper and sell the more expensive, moving prices together and promoting market efficiencyCorrect
  2. BBoth prices rise together because derivatives are always priced independently of the underlying
  3. CThe price gap persists because arbitrage is possible only in illiquid markets

Explanation

Derivatives enable arbitrage: buying the underpriced and selling the overpriced position earns riskless profit and drives prices back together. This activity makes markets more efficient. Derivative prices are linked to the underlying, and arbitrage pressure is strongest in liquid markets.

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