Final answer:
The practice of exploiting security mispricing for risk-free economic profit is known as arbitrage. The correct option is (1).
Step-by-step explanation:
The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called arbitrage. Arbitrage involves taking advantage of the price differences of identical or similar financial instruments on different markets or in different forms.
For example, if a stock is listed at different prices on two stock exchanges, a trader could buy the stock at the lower price on one exchange and sell it at the higher price on the other, earning a risk-free profit in the process.
This is possible because financial markets are not always perfectly efficient, and sometimes they offer opportunities for investors to make a profit without any risk if they act quickly to exploit these pricing discrepancies.
Investors in the financial market consider several important factors, including risk, return, liquidity, and the time frame of their investments.
They also consider market efficiency, which is the ability of the market to correctly price securities based on available information.
In a perfectly efficient market, arbitrage opportunities would not exist because all securities would be priced perfectly according to their inherent risks and returns.
However, due to imperfect information and other market frictions, arbitrage opportunities can occasionally arise.
As the market system acts as an efficient mechanism for information, investors can use price movements as signals to make informed decisions.
However, price controls and other market interventions can disrupt these signals and lead to poor allocation of financial capital.