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Explanation:
Arbitrage-free models are primarily used for quoting the prices of securities that are not actively traded based on the prices of more liquid securities. This is because arbitrage-free models are designed to eliminate the possibility of risk-free profit from price discrepancies in different markets. In other words, these models ensure that the prices of securities are consistent across different markets. When a security is not actively traded, its market price may not be readily available. In such cases, the price of a more liquid security, which is actively traded and therefore has a readily available market price, can be used as a reference to quote the price of the less liquid security. This ensures that the price of the less liquid security is consistent with the market prices of similar securities, thereby preventing arbitrage opportunities.
Choice B is incorrect. While time to maturity can influence the price of a security, it is not the primary application of arbitrage-free models. These models are primarily used to quote prices based on more liquid securities, not solely on time to maturity.
Choice C is incorrect. The economic and financial stability of the lending institute may affect the perceived risk and therefore the price of a security, but this is not directly related to arbitrage-free models. These models focus on pricing securities based on more liquid securities rather than institutional factors.
Choice D is incorrect. Although prevailing interest rates and swap rates can impact security prices, they are not the main application of arbitrage-free models. These models are designed to quote prices based on more liquid securities rather than specific market conditions like interest or swap rates.
Things to Remember
Arbitrage: Arbitrage is the practice of exploiting price differences in different markets to make a profit without risk. Arbitrage opportunities arise when the price of an asset in one market is lower than the price of the same asset in another market.
Equilibrium models: Equilibrium models, unlike arbitrage-free models, are based on the assumption that markets are in equilibrium and prices reflect all available information. These models are used to analyze the long-term relationships between various
Q.1657 Whenever any investor is buying or selling any financial instrument, it is of great importance to match its price with changes in market prices. The same case applies to the choice of the models for term structure - whether to use arbitrage-free or equilibrium models. What is the most important use of arbitrage-free models?
A
Quoting the prices of securities that are not actively traded based on the prices of more liquid securities.
B
Quoting the prices of securities that are not actively traded based on time to maturity.
C
Quoting the prices of securities that are not actively traded on the basis of the economic and financial stability of the lending institute.
D
Quoting the prices of securities that are not actively traded on the basis of prevailing interest rate and swap rates.
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