Without trading, markets cannot return to an efficient state with no arbitrage opportunity.
a. True
b. False
The correct answer and explanation is:
The correct answer is: a. True
Explanation:
Markets rely on trading to move toward an efficient state where no arbitrage opportunities exist. Arbitrage refers to the practice of taking advantage of price differences in different markets or instruments to make a risk-free profit. When such opportunities exist, traders quickly buy undervalued assets and sell overvalued ones. This activity exerts pressure on prices, pushing them toward equilibrium.
Without trading, these price discrepancies would persist because there would be no mechanism to correct them. Trading acts as a natural corrective force in financial markets. It helps align prices across different venues and instruments, reflecting all available information. This process is fundamental to the efficient market hypothesis, which states that asset prices fully reflect all known information.
When traders identify arbitrage opportunities, they execute transactions that reduce the price differences. For example, if a stock is priced lower on one exchange than another, arbitrageurs buy on the cheaper market and sell on the more expensive one. The resulting demand and supply adjustments bring prices closer together until the arbitrage profit disappears. This continual trading activity contributes to market efficiency by ensuring prices do not stray far from their fair value.
If trading did not exist, price discrepancies could remain indefinitely because no one would exploit the arbitrage chance to correct the mispricing. This would mean markets are inefficient, and arbitrage opportunities persist. Therefore, trading is essential to maintain market efficiency and eliminate arbitrage opportunities over time.
In summary, trading is a critical mechanism that enables markets to self-correct and reach a state where prices reflect true values. Without trading, markets cannot efficiently remove arbitrage opportunities, confirming the statement as true.