I received this question and I am stumped.
Arbitrage activity will most likely be higher in securities markets:
A) With high information acquisition costs.
B) That are efficient
C) With no restrictions of short selling.
I picked A and the answer is C, here is the explanation
Short selling helps in price discovery. Arbitrageurs benefit from pricing discrepancies (inefficiences); therefore, arbitrage activity will be higher in markets with no restrictions on short selling.
Can some one please explain why the answer is C? I am confused on this one…Wouldn’t the ability to short sell increase market efficiency and decrease arbitrage opportunities? I interpret no restriction on short selling as it is allowed.
Suppose that the spot price on a stock is $100 and the 1-year risk-free rate is 3%. If the 1-year forward price is $102, then there is an arbitrage opportunity . . . as long as you’re allowed to sell short. If you’re not, you cannot make this arbitrage profit.
Thanks a ton! I think I understand as I was interpreting the question wrong.
Because through short selling your are able to take advantage of arbitrage opportunities there will be more arbitrage activity (those that are taken through short selling) Please correct me if this is wrong.
I picked A as well but if you read it carefully, it’s asking when will arbitrage activity will be higher? If information costs are high, there will be less arbitrage activity not more of it, so A is wrong. I didn’t pay close attention to the question and got it wrong as well.
I am still a little confused help needed. My understanding was that If there is no restriction on short selling then the price would adjust quickly and opportunities would be low. On the contrary if information is costly then there would be mispricing and greater opportunities for arbitrage. Please help
its just english grammar. i hate these kind of questions.
It is just the phrasing that is probably confusing as it was for me. Having “higher” arbitrage opportunities means that there are more ways to have arbitrage by utilizing one of these methods. By being able to short sell you are able to take advantage of more arbitrage opportunities (because they require shot selling)
Hope this helps.