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CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives

When an arbitrage opportunity exists because a derivative is priced below its no-arbitrage value, the actions of arbitrageurs buying the derivative will most likely cause:

Arbitrageurs buying the underpriced derivative will push its price up until it reaches the no-arbitrage value and the profit disappears. The risk-free rate is determined by wider markets and does not adjust to such trades.

  1. Athe derivative price to rise until the opportunity disappearsCorrect
  2. Bthe underlying asset price to fall until the opportunity disappears
  3. Cthe risk-free rate to fall until the opportunity disappears

Explanation

Buying pressure on the underpriced derivative pushes its price up toward the no-arbitrage value. Arbitrageurs also sell or short the underlying, but the key adjustment here is the derivative price rising. The risk-free rate is set in broader markets and is not changed by this trade.

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