Answer to Chapter 1 Introduction to Derivatives & Risk Management, Chance, Brooks.

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1.(Market Efficiency and Theoretical Fair Value) An efficient market is one in which prices reflect the true economic values of the assets trading therein. In efficient markets, no one can earn returns that are more than commensurate with the level of risk. Efficient markets are characterized by low transaction costs and by the rapid rate at which new information is incorporated into prices.

2.(Arbitrage and the Law of One Price) Arbitrage is a type of investment transaction that seeks to profit when identical goods are priced differently. Buying an item at one price and immediately selling it at another is a type of arbitrage. Because of the combined activities of arbitrageurs, identical goods, primarily financial assets, cannot sell for different prices for long. This is the law of one price. Arbitrage helps make our markets efficient by assuring that prices are in line with what they are supposed to be. In short, we cannot get something for nothing. A situation involving two identical goods or portfolios that are not priced equivalently would be exploited by arbitrageurs until their prices were equal. The "one price" that an asset must be is called the “theoretical fair value.”

3.(Arbitrage and the Law of One Price) The law of one price is violated if the same good is selling at different prices. On the surface it may appear as if that is the case; however, it is important to look beneath the surface to determine if the goods are identical. Part of the cost of the good is convenience and customer service. Some consumers might be willing to pay more because the dealer is located in a more desirable section of town. Also, the higher priced dealer may have a better reputation for service and customer satisfaction. Buyers may be willing to pay more if they feel that the premium they pay helps assure them that they are getting a fair deal. It is important to note that many goods are indeed identical and, if so, they should sell at the same price, but the Law of One Price is not violated if the price differential accounts for some economic value.

4.(The Storage Mechanism) Storage is simply holding the asset. Some assets, like commodities, require considerable storage space and entail significant storage costs. Others, like stocks and bonds, do not consume much space but, as we shall see later, do incur costs. Storage enables us to more adequately meet our consumption needs and, thus, provides for a more efficient alteration of our consumption patterns across time. For example, we can store grains for the winter. In the case of stocks and bonds, we can store them and sell them later. The proceeds from the sale of the securities can be used to meet consumption needs at the later time. Likewise, storage enables speculators to hold goods and securities in the hope of selling them later at a profit. In addition, storage plays an important role in defining the relationship between spot instruments and derivatives.

5.(Delivery and Settlement) In futures markets, delivery seldom occurs. Since delivery is always possible, however, an expiring futures contract will be priced like the spot instrument. The knowledge that futures prices will eventually converge to spot prices is important to the pricing of futures contracts.

6.(The Role of Derivative Markets) Derivative markets provide a means of adjusting the risk of spot market investments to a more acceptable level and identifying the consensus market beliefs. They make trading easier and less costly and spot markets more efficient. These markets also provide a means of speculating.

7.(Criticisms of Derivatives Markets) On the surface, it may be difficult to distinguish speculation from gambling. Both entail high risk with the expectation of high gain. The major difference that makes speculation somewhat more socially acceptable is that it offers benefits to society...
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