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Finance - Math Problem Example

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It is basically a position taken by an investor in one market to neutralize the risk related to a contrasting position taken in another market. In incomplete markets, perfect risk…
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Hedging and Arbitrage Hedging is an investment strategy employed by investors to avoid certain potential business risk. It is basically a position taken by an investor in one market to neutralize the risk related to a contrasting position taken in another market. In incomplete markets, perfect risk cannot be transferred. As a result, investors cannot come up with a perfect hedging portfolio that does away with all the associated risks (Mishken et al. 2009). Some of the causes of incomplete markets are transactional costs, market resistances and portfolio constraints. Due to these reasons, investors are forced to take up cross-hedging in this market. This normally involves hedging a position in one asset by taking a balancing position in different asset that highly correlates with the first asset (Mishken et al. 2009).
Complete markets are those markets where every conditional claim is attainable. In this market, there exists a stable price for every asset in all possible positions. As a result, investors can buy insurance contracts to protect against uncertainty in future states and time (Mishken et al. 2009).
Arbitrage involves taking concurrent positions in diverse assets such that a riskless profit which is more than the yield on the riskless asset is guaranteed. First arbitrage occurs when an investor makes an investment with no existing net assurance that there would be a positive profit. Second arbitrage occurs when an investor has the opportunity to make an investment with a negative net commitment at that time. Prices are said to be fair if and only if there exists no arbitrage.
Works Cited
Mishken, Frederic S., and Stanley G. Eakins. Financial markets and institutions. 6th ed. Boston: Pearson Prentice Hall, 2009. Print. Read More
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