Question 7

Which of the following about the risk of arbitrage is correct?

I: In theory, arbitrage is riskless because it is a long-short hedged position.

II: in theory, it is riskless because eventually price has to go back to fundamentals. There is no uncertainty on this outcome.

III: In reality, even if eventually price will go to fundamentals, arbitrageurs maybe forced out of the market because of the risk of margin call.

IV: In reality, if lenders do not dare to lend enough capital to arbitrageurs, then arbitrageurs may not have enough capital to push price back to fundamentals. Price could always be wrong, thus making the arbitrage position not riskless.

Question 8

Steve has a diversified portfolio of high book-to-market stocks, while Brian has a diversified portfolio of low book-to-market stocks. Suppose you live in a Fama-French 3-factor model world.

I. Steves portfolio is more likely to be overvalued than Brians

II. Steve prefers riskier stocks

III. Steves portfolio is more likely to perform badly in recessions

		III
		I and II only
		II and III only
		I and III only