Which of the following is inconsistent with the notion that there are no arbitrage opportunities?Question 1Select one:Investment strategy A is very safe. No matters what happens, it will generate a guaranteed payoff at time T of $100.In contrast, the future payoff to investment strategy B is highly uncertain -- it could be high or low. Nevertheless, strategy B has an expected payoff is $100. Since A and B both have expected payoffs of $100, the cost to enter both strategies today must also be identical.The future payoff to an investment strategy is known today with complete certainty. Therefore, the spot price to enter this strategy today will be such that whoever enters today will earn the riskfree rate of interest over the investment horizon.Investment strategy A always generates the same future payoff as investment strategy B. It follows that the current price to enter A must be identical to the current price to enter B.An investment product is structured such that its payoff at future time T is guaranteed to be $0. It follows that the current price to enter this strategy must also be $0.All of the above are consistent with the notion that there are no arbitrage opportunities.
Question
Which of the following is inconsistent with the notion that there are no arbitrage opportunities?Question 1Select one:Investment strategy A is very safe. No matters what happens, it will generate a guaranteed payoff at time T of 100. Since A and B both have expected payoffs of 0. It follows that the current price to enter this strategy must also be $0.All of the above are consistent with the notion that there are no arbitrage opportunities.
Solution
The statement that is inconsistent with the notion that there are no arbitrage opportunities is: "Since A and B both have expected payoffs of $100, the cost to enter both strategies today must also be identical."
This is inconsistent because the risk associated with each investment strategy is not taken into account. Even though the expected payoffs of investment strategies A and B are the same, the risk associated with each strategy is different. Strategy A is very safe and provides a guaranteed payoff, while the payoff of strategy B is highly uncertain.
In a market with no arbitrage opportunities, an investment with higher risk is expected to have a higher potential return to compensate for the additional risk. Therefore, the cost to enter (or the price of) these strategies should not be the same. The price of strategy B should be lower to compensate for its higher risk.
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