Financial Risk Manager Part 1

Explanation

This question describes risk-free arbitrage, which occurs when an investor can exploit pricing discrepancies in the market to earn a risk-free profit. Here's why:

Key Characteristics of Risk-Free Arbitrage:

• Violation of equilibrium price relationship: When assets are mispriced relative to their fundamental relationship
• Large position size: Arbitrageurs take maximum positions to maximize profits since the opportunity is risk-free
• Risk-free profit: The strategy involves no risk when executed properly

Why Other Options Are Incorrect:

• B. Capital Asset Pricing Model (CAPM): This is a theoretical model for pricing risky securities, not an investment strategy
• C. Mean-Variance Frontier: This represents the set of optimal portfolios that offer the highest expected return for a given level of risk
• D. Single Factor Security Market Line: This is the graphical representation of CAPM showing the relationship between expected return and systematic risk

Arbitrage in Practice:

When equilibrium relationships (like put-call parity, covered interest parity, or law of one price) are violated, arbitrageurs immediately exploit these opportunities by taking large positions until the mispricing disappears, restoring market efficiency.