Finc derivatives pricing concepts and arbitrage

Q: Why use continuously compounded interest rates in pricing forwards/futures?

A: They simplify calculations and account for continuous growth of capital.

Q: What is arbitrage?

A: Exploiting mispricing to earn a risk-free profit.

Q: What is the key assumption about arbitrage in markets?

A: No-arbitrage opportunities exist; mispricings are corrected by market forces.

Q: How do arbitrageurs restore no-arbitrage prices?

A: Buy the underpriced asset and sell the overpriced asset until prices align.

Q: What is a general arbitrage strategy?

A: Sell overpriced asset, buy underpriced asset, lock in risk-free profit.

Q: What are the four assumptions of perfect capital markets?

A: No transaction costs, constant tax rates, borrowing/lending at risk-free rate, no arbitrage.

Q: What are investment assets?

A: Assets held by traders for investment purposes (stocks, bonds, FX).

Q: What are consumption assets?

A: Assets held mainly for consumption (commodities like oil, corn, soya).

Q: What is the cost of carry (c)?

A: Total financing, storage costs, and net income of holding an asset.

Q: Why do commodities have storage costs?

A: Physical storage is required; costs reduce net return (negative income).

Q: What is convenience yield (y)?

A: Benefit from holding a physical asset; reflects expected future shortage.

Q: Why doesn't no-arbitrage pricing always hold for consumption assets?

A: Storage costs and convenience yields create inequality: F0 <= (S0+u)e^rt