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Solve the following problem:
Consider two securities that pay risk-free cash flows over the next two years and that have the current market prices show here:
Security Price Today Cash Flow in One year Cash Flow in Two years
B1 94 100 0
B2 85 0 100
a. What is the no-arbitrage price of a security that pays cash flows of $100 in one year and $100 in two years?
b. What is the no-arbitrage prices of a security that pays cash flows of $100 in one year and $500 in two years?
c. Suppose a security with cash flows of $50 in one year and $100 in two years is trading for a price of $130. What arbritrage opportunity is available?
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What is arbitrage process?
Arbitrage is process of utilising differences in price in two markets to make financial gains. Generally each market has a different demand-supply position and hence price of same product is different in different market.
What are the shortcomings of the binomial pricing model?
b) Binomial pricing model doesnt provide for the possibility of price of the underlying remaining the same between two consecutive time points (it assumes that either the price could go up or could come down; it completely ignores the possibility of the price not changing at all) a) Binomial pricing model breaks up the time to the expiry of option in to a limited number of time intervals and hence, the price calculated through binomial trees is more of a broad approximation of the actual price. (Compare this with Black Scholes (BS) Model which gives a more accurate approximation because the BS model involves breaking the time to expiry into infinitesimaly small time intervals).
What is 3C Model for price Setting?
The 3 C's model for setting pricestakes into account the customer, our costs, and the competition. Customer's perception about the various attributes of the products, competitor's pricing and our own total costs.
What are arbitrage situations?
An example of arbitrage was declared against a county that obtained $10 million in bonds for the purpose of developing a landfill. Some of the bond money was used for a land purchase and engineering studies. For several reasons the landfill was never built. The county put the remaining bond money into CDs at their local bank and drew a higher rate of interest than they were paying bondholders. The government charged the county with arbitrage and charged a fine.
What does the term arbitrage profit means?
Arbitrage profit is profit derived from a riskless (or near riskless) transaction. For example, say gold is selling on the London exchange for $800 per oz and gold is selling on the New York exchange for $804 per oz. Buying one oz of London gold and selling one oz of New York gold (trades in close proximity) provides an arbitrage profit of $4 (less transaction fees). The purchase and sale will likely have the effect of increasing the price of London gold and decreasing the price of New York gold. So for every subsequent trade, the arbitrage profit will be lower and lower until the prices are at parity.
