Arbitrage question

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ruhi22

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Which of the following is the best interpretation of the no-arbitrage principle?

A. There is no free money.
B. The information flow is quick in the financial market.
C. There is no way you can find an opportunity to make a profit.
D. People can never beat the market.

I selected the wrong answer...any inputs? The answer is A. Why is it not B?
 
tricky... i would say that A is a better "definition" or interpretation of no arbitrage principle, and B is a condition or requirement for the no-arbitrage principle to actually be true.
 
nolabird,

thanks for your reply...I still have a doubt though...my understanding is that arbitrage is a risk free profit without any upfront investment from our side..so, what does "free money" here mean?
 
I hate the semantics in questions like that. Note that the question asks for an INTREPRETATION, which in this case is A.

As nola pointed out, B is a necessary condition, and from a semantic point of view there's a difference between interpretation and necessary condition. Tricky, tricky.... I hope we don't get a lot of questions like that on the actual exam.

Where did you get this question from, ruhi?
 
Terrible question. I wouldn't have gotten it without having been given the answer but I understand why it is A. Arbitrage is essentially a risk-free way of making guaranteed money, so it is essentially "free money," at least in theory.
 
lola, i got it from good ol' schweser...everybody thanks for your answers...I couldn't understand what they meant by free money.
 
I'll add my voice to the chorus that this is a stupidly worded question, but I did get it right. In my college courses my professors talked a lot about arbitrage as essentially being "free money".

The reason I wouldn't go with B is the wording. While information flow could be quick that doesn't insinuate that you can't be the first one in and profit from it. If it said something like "Information flow is instantaneous" or even "Information flow is efficient" then it would have been more correct.
 
"Quick" in B implies that the free money goes away fast, but if it were really no-arbitrage, there wouldn't be any free money, riskless money to be made. Might not be the best worded question ever, but I'd happily take 240 of these on the test over capital lease questions any day of the week!
 
yeah..I see what that free money means now...the wording of the question caught me...I hope this doesn't happen on the test day.
 
bann, the only thing is, in the "real" world, there is rarely "free money" even in arbitrage because in order to profit in arbitrage, often a huge transaction must be undertaken and often there is considerable leverage used, not to mention transaction costs. Of course, with leverage comes interest and with interest comes the expense to the arbitrage transaction; thus, arbitrage in the real world is rarely "free money" which is why the question is just a stupid question, but is correct in purely academic settings.

I guess we have to remember that the CFA exam is purely academics. For example, CAPM has a number of ridiculous assumptions, as well as the Markowitz Portfolio Theory, but for the most part, the CFAI won't test on the "real world." That's what throws me off when I read questions like this one. It could be the MOST correct answer, but not necessarily correct.
 
That is just not so.

The CFA exam makes sure that you have the basics down in lots of areas. Arbitrage arguments, CAPM, tangency ideas, Markowitz portfolio theory, etc. are all very important in the real world. They are starting points for all kinds of important thinking that is done all the time. If you don't understand the ideas in these things, you will never get the more complicated "real-world" stuff that has trading costs, different borrowing and lending rates, liquidity issues, etc.. It's not that it's "academic"; it's that it's got to be simplified. Real world mean variance optimization in my world runs through Bayesian analysis and quadratic programming. Want to do that on the test?
 
Joey, you and I agree. The original question in this thread though was "difficult" because if you think about it in "real" terms then the answer given is not necessarily correct. Thus my last statement was simply saying that it's something we need to be on guard for as test-takers. You're right though that it isn't just "academic." That was hyperbole on my part, I guess.



Edited 1 time(s). Last edit at Friday, April 13, 2007 at 07:16PM by kkent.
 
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