CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
An arbitrageur observes that a derivative trades above the cost of its replicating portfolio. The most appropriate arbitrage action is to:
The arbitrageur should sell the overpriced derivative and buy the cheaper replicating portfolio. The payoffs offset in every future state, so the initial price difference is a riskless profit, and trading pressure pushes prices back toward equality.
- Abuy the derivative and buy the replicating portfolio.
- Bsell the derivative and buy the replicating portfolio.Correct
- Cbuy the derivative and sell the replicating portfolio.
Explanation
Selling the overpriced derivative and buying the cheaper replicating portfolio locks in the price difference today, and the payoffs offset in every state at expiry. The other combinations either double exposure or buy the expensive asset.
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