Practice Quiz

FRM Financial Risk Manager Practice Test

Category - Arbitrage

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Tom is looking at the morning’s currency reports and notices that 1 Nigindia rupee equals 1.5 Vietbodian pounds. It also reads that 1 Vietbodian pound equals 2 Mexicali pesos, but 1 Nigindia rupee equals 4 Mexicali pesos. Tom wants to gain profits by employing an arbitrage strategy. Which of the following defines arbitrage strategy?
  1. An arbitrage strategy is a risky strategy to buy something at a low price and sell it at a high price.
  2. An arbitrage strategy is a pattern of trade that allows the exchange in currencies.
  3. An arbitrage strategy is a pattern of trade that exploits the discrepancies between the prices of different assets in order to earn profit without bearing any risk.
  4. An arbitrage strategy is a strategy that requires risky behaviors and a high setup cost.
Explanation
An arbitrage strategy is a pattern of trade that exploits the discrepancies between the prices of different assets in order to earn profit without bearing any risk.
Arbitrage is possible when one of three conditions is met:
1- The same asset does not trade at the same price on all markets, thus violating the Law of One Price.
2- Two assets with identical cash flows do not trade at the same price.
3- An asset that has a known price in the future is not trading at that price.

Key Takeaway: In order to avoid market risk, the transactions must occur simultaneously. So in Tom’s scenario, it would be important for him to ensure that all the trades required to perform his currency arbitrage occur simultaneously. In today’s highly efficient markets, trading bots and slick traders take advantage of arbitrage opportunities in an instant.
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