Chartered Financial Analyst Level 2
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- When valuing a commodity contract, is the settlement method likely to affect whether the law of one price will be enforced by arbitrageurs?
Exam-Like
A
No
B
Yes, it is more likely to be enforced if the contract settles in cash
C
Yes, it is more likely to be enforced if the contract settles using physical delivery
Explanation:
Explanation
The correct answer is C because physical delivery settlement makes arbitrage more effective in enforcing the law of one price.
Key Points:
-
Physical delivery allows arbitrageurs to:
- Take delivery of the physical commodity
- Store or transport it
- Sell it in another market where prices are higher
- This creates direct arbitrage opportunities
-
Cash settlement limits arbitrage effectiveness because:
- Arbitrageurs cannot take possession of the physical commodity
- They rely on price convergence at settlement
- Transaction costs and basis risk may prevent perfect arbitrage
-
The law of one price states that identical assets should have the same price across different markets
-
Arbitrage is the mechanism that enforces this law by exploiting price differences
-
Physical delivery provides the most direct mechanism for arbitrageurs to profit from price discrepancies
Therefore, commodity contracts that settle via physical delivery are more likely to have the law of one price enforced by arbitrageurs.
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