Question

Next, consider another pair of assets, C and D. Asset C will make a single payment of $300 in 1 year, while D will make a single payment of $400 in 1 year. Assume that the current price of C is $240 and that the current price of D is $360.

c. What are the rates of return of assets C and D at their current prices?

     Return on asset C =

     Return on asset D =

Given these rates of return, which asset should investors buy, and which asset should they sell?

     Buy asset: C or D and Sell asset: C or D.

d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?

No, they will have different prices

There is insufficient data to determine the prices.

Yes, they will have the same price.

Compare your answers to questions a through d before answering question e.

e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices?

No

Yes

In what situations will it also equalize prices?

When payoffs are the same.

Under no situation.When payoffs are different.

Answer 1

(c) Rate of return on C = ((final return- cost of asset)/cost of asset)*100

= ((300-240)/240)*100 = 25%

Rate of return on D = ((400-360)/360)*100 = 11.11%

Since the rate fo return on C is higher, the best decision is to buy C and to sell D

(d) No, they will have different prices when arbitrage ends as the final payment is different. Thus, the price that equalizes their ROR will be different. This is beacuse no arbitrage means their ROR is equal, and since they have different final payoffs, their initial costs can not be the same.

(e) No, equal ROR does not guarantee equal prices as seen in (d)

(f) It can only happen when the final payoffs are the same.