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

Which statement about arbitrage and derivative pricing is most accurate?

Derivative prices are determined by the absence of arbitrage, because a derivative's payoff can be replicated with the underlying and risk-free borrowing. This makes risk preferences and expected spot prices irrelevant and allows valuation under risk-neutral probabilities.

  1. AArbitrage opportunities should persist, since derivative prices reflect investor risk preferences.
  2. BDerivative prices are set using the underlying's expected future spot price and the investors' risk aversion.
  3. CDerivative prices are set so that no arbitrage exists, and risk-neutral valuation is possible because of this.Correct

Explanation

Derivatives can be replicated with the underlying and risk-free borrowing or lending, so their prices are fixed by no-arbitrage conditions rather than risk preferences or expected spot prices. This is why risk-neutral pricing works. The other statements contradict this.

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