Question

# In the one-period binomial model, let d be the down factor and let r be the...

In the one-period binomial model, let d be the down factor and let r be the risk-free rate. What will be the arbitrage opportunity if d > 1 + r?

If d > (1 + r) we can create an arbitrage opportunity by borrowing an amount equal to the current stock pirce, S and buying one unit of stock.

Since d > (1 + r); hence, d - (1 + r) > 0

 Action at time 0 t = 0 t = T Borrow @ risk free rate S - (1 + r) x S Buy stock - S d x S Total 0 d x S - (1 + r) S = [d - (1 + r)] x S >0

Thus you end up making a riskfree and riskless profit of [d - (1 + r)] x S at t = 1 without any initial investment. This is the arbitrage profit.

#### Earn Coins

Coins can be redeemed for fabulous gifts.

##### Need Online Homework Help?

Most questions answered within 1 hours.

##### Active Questions
• Infinity Designs, an interior design company, has experienced a drop in business due to an increase...
• What is the difference between prezygotic and postzygotic reproduction barriers (reproductive isolating mechanisms, RIMs) between species...
• What government policies are likely to restrict international trade? Are these effects likely to affect that...
• PEST Analysis on Art Gallery in Canada? (Toronto) - Political - Economic - Social - Technological
• What activities or functions do all managers perform regularly? How do these functions apply to the...
• Critically evaluate Geoff Scott’s argument that shareholders are expecting a dividend and if not paid one...