Question

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

XYC= $41                                      (2) State: Bad

                                                            ABC = $80

                                                             XYZ = $40

Answer 1

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.