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IAI Actuarial Core Principles · Business Finance · Key principles of finance

Which statement best describes pure arbitrage in financial markets?

Pure arbitrage is earning a risk-free profit with no net outlay by exploiting a price difference between equivalent assets. Other strategies like speculation, short selling on a view, or borrowing to buy riskier assets all carry risk, so they are not arbitrage.

  1. ABuying an undervalued share in the expectation that its price will rise over several years
  2. BEarning a risk-free profit with no net outlay by exploiting a price difference between equivalent assetsCorrect
  3. CHolding a diversified portfolio to eliminate specific risk
  4. DBorrowing at a low rate to invest in a higher-yielding but riskier bond
  5. Selling a share short because it is believed to be overvalued

Explanation

Pure arbitrage requires a riskless gain with no investment, achieved by exploiting mispricing of identical or equivalent cash flows. The other options all involve bearing risk, such as price movement or credit risk, so they are speculation or diversification rather than arbitrage.

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