ACCA Financial Management (F9) Certification Practice Exam

In the context of capital budgeting, what concept explains the phenomenon of arbitrage?

1. Investing in high-risk stocks

2. Purchasing securities in one market for immediate resale in another

3. Buying assets and holding them indefinitely

4. Using derivatives to hedge against losses

The correct answer is: Purchasing securities in one market for immediate resale in another

The concept of arbitrage is best explained by the phenomenon of purchasing securities in one market for immediate resale in another. This strategy capitalizes on price discrepancies that can occur between different markets or exchanges. When an asset is undervalued in one market compared to another, an investor or arbitrageur can buy it where it is cheaper and sell it where it is more expensive, thereby locking in a risk-free profit. This practice is fundamental to ensuring market efficiency, as it helps to equalize prices across different venues. If an asset is priced lower in one location, the buying action will eventually drive the price up in that market, while the selling action in the higher-priced market will bring that price down. Consequently, this balancing act performed by arbitrageurs plays a crucial role in maintaining the overall stability and fairness of financial markets. The other options revolve around different investment strategies and risk management approaches but do not encapsulate the essence of arbitrage as effectively as the correct choice does. Investing in high-risk stocks and buying assets to hold indefinitely focuses on investment strategy and risk appetite, while using derivatives is more related to managing financial risk rather than exploiting market price discrepancies.