Question

# At Time O, asset ABC is selling for \$85 and XYZ is selling for \$41. These...

At Time O, asset ABC is selling for \$85 and XYZ is selling for \$41. These assets' prices at Time 1 are given under two states ofthe economy (refer to Figure 1.1 below). Assume "short selling" ia allowed. That is, you can borrow units of ABC and/or XYZ from your broker. Using the concept of "Arbitrage and the Law of One Price".

Figure 1.1

Time 0                                               Time 1

(1) State: Good

ABC = \$100

XYZ= \$50

ABC= \$85

ABC = \$80

XYZ = \$40

Price of asset ABC at time 0 = \$85

Price of asset XYZ at time 0 = \$41

Scenario 1:- If the economy is in a good state

Price of asset ABC at time 1 = \$100 which is higher than its spot price

Price of asset XYZ at time 1 = \$50 which is higher than its spot price

So, you should buy ABC & XYZ in spot and sell them in forward to earn the price differentials.

Scenario 2:- If the economy is in a bad state

Price of asset ABC at time 1 = \$80 which is lower than its spot price

Price of asset XYZ at time 1 = \$40 which is lower than its spot price

So, you should short sell ABC & XYZ in spot and buy them in forward to trade on this price differential.

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