CHAPTER 1: I 1. (The Role of Derivative Markets) The existence of derivative markets in the United States economy and indeed throughout most modern countries of the world undoubtedly leads to a much higher degree of market efficiency. Derivatives facilitate the activities of individual arbitrageurs so that unequal prices of identical goods are arbitraged until they are equal. Because of the large number of arbitrageurs, this is a quick and efficient process. Arbitrage on this large a scale makes markets less capable of being manipulated, less costly to trade in, and therefore more attractive to investors. (The opportunity to hedge also makes the markets more attractive to investors in managing risk.) This is not to say that an economy without derivative markets would be inefficient, but it would not have the advantage of this arbitrage on a large scale. It is important to note that the derivative markets do not necessarily make the U.S. or world economy any larger or wealthier. The basic wealth, expected returns, and risks of the economy would be about the same without these markets. Derivatives simply create lower cost opportunities for investors to align their risks at more satisfactory levels. This may not necessarily make them wealthier, but to the extent that it makes them more satisfied with their positions, it serves a valuable purpose. 2. (Return and Risk) Return is the numerical measure of investment performance. There are two main measures of return, dollar return and percentage return. Dollar return measures investment performance as total dollar profit or loss. For example, the dollar return for stocks is the dollar profit from the change in stock price plus any cash dividends paid. It represents the absolute performance. Percentage return measures investment performance per dollar invested. It represents the percentage increase in the investor’s wealth