Arbitrage and Financial

Decision Making
F650 Winter 2021
Module 02 Part 1: Asynch
Professor Katya Malinova
 Readings for this set of slides

• The key takeaway for these slides (parts 3-5) are based on
Subsection 3.6 from the Berk et al textbook.
• The goals of parts 1-2 is to bring us on the same page
terminology-wise
 Part 1: what do we mean by “risk-free”?

Making sure that we are on the same

page definition-wise!
Risk-free vs. risky

• Risky:

• Actual outcome may differ from

expected

• Or, in other words:

• Outcome tomorrow depends on the

state of the world
 Risk-free vs. risky
• The economy will be either weak or strong in one year (i.e., 2 possible states of
the world, but we don’t know which one will occur).

• A security has a price of $50 today.

• All payoffs are “gross” payoffs = cash flows at the end of the year.

• Are the following “risk-free” or “risky”?

these money values are
the cash flows you receive
$30 at the end of the year

Security #1 Risky
Price =$50
$60
 Risk-free vs. risky
• The economy will be either weak or strong in one year (i.e., 2 possible states of
the world, but we don’t know which one will occur).

• A security has a price of $50 today.

• All payoffs are “gross” payoffs = cash flows at the end of the year.

• Are the following “risk-free” or “risky”?

$55
Security #2 Risk-Free
Price =$50
$55
 Risk-free vs. risky
• The economy will be either weak or strong in one year (i.e., 2 possible states of
the world, but we don’t know which one will occur).

• A security has a price of $50 today.

• All payoffs are “gross” payoffs = cash flows at the end of the year.

• Are the following “risk-free” or “risky”?

$55
Security #3 Risky
Price =$50
even though ur not losing
$70 money, its still risky since the
outcome is not constant
 Part 2: what do we mean by return?

Making sure that we are on the same

page definition-wise!
Return & Expected Return

• Many different terms that include

“return”

• We will introduce them as we need

them

• For now: back to basics!

Return: Basics
Return: Basics

Consider a one-year bond from lecture 1:

• Price $952.38
• Face value $1,000

What does this mean?

• Pay $952.38 today to purchase the bond
• Receive $1,000 on your account
tomorrow
• Often refer to the $1,000 as (gross)
payoff
Return: Basics

Net return, rate of return,

commonly simply “return”
 Return: Basics

Often refer to the difference as “gain”

(or informally as a loss when negative)
Return: Basics

Why do we typically use “returns” (rather than “prices”) to

compare securities? when we have prices its different to compare different
securities cuz they have diff cash flows, dividends,
timing of everything, returns has a simple meaning

Return = percentage increase in the value of an

investment per $1 initially invested in a security hence its ez to compare
across diff securities
Return: Notation

When talking about return on a risk-free asset,

we often use subscript “f”:

this means she is trying to demonstrate the “risk-free rate”

Price vs. Return

When cash flows are fixed, higher

prices correspond to lower returns!
PV of future cash flows (in this case its 1 period)

This is a simple one period example but true more

generally! this theory is true for situations w/ more than 1 period
Return: Expected Return

now we’re introducing new

terms for when there’s risk
involved as most securities are
not risk free
Expected Return: example

Consider an exchange-traded fund, or an ETF, on the

market index (loosely: this investing in this asset means
investing into a portfolio of all stocks in the financial
market):

$80
0
Price
=$1,000
Expected Return: example

when we say return, it means net return (which is why we subtract $1,000)
Expected Return: example

The expected return can also be computed as a weighted

average of the actual returns (weighted by the probabilities of the
outcomes):
Part 3: risk aversion and risk premium
 Risk Aversion

• Risk aversion: the notion that investors prefer a safe

outcome rather then a risky one.

• Earlier example:
• investors are willing to pay $1,000 today for the risky
ETF
• to receive $1,100 on average at the end of the year.
• Risk aversion =>
• If investors are offered a risk-free bond that pays
$1,100 at the end of the year with certainty
• => they would be willing to pay more than $1,000 for
it.
 Risk Aversion

• There are caveats to the above

• will revisit when we discuss how to measure “risk”!

• For now, note that the market index ETF pays:

• $300 less than expected when the economy is weak
• $300 more than expected when the economy is strong

• [Most] investors dislike this type of risk

• => Expect to earn more than the risk-free rate when
investing in the market index.
• The difference between the return on the ETF and the
risk-free rate = market risk premium
 Risk Premium

• When investing in any risky project/asset, investors expect a

return that appropriately compensates them for the risk.

• When a cash flow is risky, we

• discount the expected cash flow
• @ a rate = risk-free interest rate + an appropriate risk
premium.

• Basic idea: use the market risk premium to determine the

appropriate risk premium (and thus prices) for other assets.
• General approach: later in the course (e.g., CAPM).
• For now: two numerical examples of pricing risky assets
 Background Info for Examples 2 and 3: payoffs

• Suppose the risk-free rate is 4%, and the economy is

equally likely to strengthen or to weaken (probability ½ of
either outcome).

• You can invest into two assets:

1. A one-year, zero-coupon risk-free bond with a face
value F of your choice.
2. An ETF (exchange-traded fund) on the market index.
Assume that the payouts of this ETF are known. One
ETF unit pays:

• $1400 if the economy is strong

• $800 if the economy is weak
Part 4: pricing risky securities

general idea would be to use the market risk premium

(which is the easiest to estimate) to determine risk
premium for other securities
 Using the Law of One Price for Risky Securities
Example A

• Economy in one year: weak or strong with equal probabilities.

• Risk-free rate = 4%.

cash flows in one year

Security Price today weak economy strong economy
Security A ??? 0 600
Market Index ETF 1,000 800 1400
Risk-free Bond 769.23=800/1.04 800 800
goal is to use the low of 1 price (i.e if u get the same
payoff it should cost the same to price security A

• Goal: price security A using the Law of One Price.

 Using the Law of One Price for Risky Securities
Example A

The cash flows

the cash from
flows from thisthis portfolio
portfolio identical to the cash
is IDENTICAL
to the cash flows from the ETF (no matter what
flows from the ETFof (no
the state matter
the economy is!) what the state of the
economy is!):
so from the investor’s perspective in terms of the payoffs 1 year from now, ur completely indifferent btn holding
an ETF on the market index vs holding security A and the risk-free bond, this means that you should be willing
to pay exactly the same for the portfolio of security A and risk-free bond as you are for the ETF
Using the Law of One Price for Risky Securities
Example A

cash flows in one year

Security Price today weak economy strong economy
Security A 230.77 0 600
Risk-free bond 769.23 800 800
ETF 1,000 800 1,400

By the Law of One Price:

Price (A) + Price (Risk-Free Bond) = Price (ETF)
Price (A) + 769.23 = 1,000

=> Price (A) = 1,000 – 769.23 = $230.77

 Risk premiums depend on risk
Example A
expected return of ETF is only 10%
(u can check with calc on ur own)

Security A has a much higher expected return than the the ETF:

4 is the risk free rate here

Why is the risk premium of security A so

much higher than that of the market
index?
Compute the actual returns for A and the ETF

Returns on A are much more

variable/volatile
Part 5: pricing risky securities

Why return variability does

not tell the whole story
 Using the Law of One Price for Risky Securities
Example B
• Instead of security A, consider security B that pays $0 in a
strong economy and $600 in a weak economy:
cash flows in one year
Security Price today weak economy strong economy
Security B ??? 600 0
ETF 1,000 800 1400
Risk-free Bond 1346.15 = 1400/1.004 1400 1400

• To make it easier to find a portfolio of two securities that

replicates the payoff of the third, we will use the risk-free
bond that pays $1,400 in one year.
Using the Law of One Price for Risky Securities
Example B

investors should be indifferent holding the risk free

bond vs holding the portfolio of security B and ETF

This portfolio pays $1,400 risk-free (same as the bond!)

Using the Law of One Price for Risky Securities
Example B

cash flows in one year

Security Price today weak economy strong economy
Security B 346.15 600 0
ETF 1,000 800 1,400
Risk-free bond 1,346.15 1,400 1,400

By Law of One Price: Price (B) + Price (ETF) = Price (Bond)

=> Price (B) = 1,346.15 – 1,000 = $346.15

 Using the Law of One Price for Risky Securities
Example B

• Security B has a negative expected return (despite being risky!) :

• Expected Payoff = (1/2) x 0 + (1/2) x 600 = 300.

• Expected return of B = (300 – 346.15)/346.15 = -13.3%

• Security B has the risk premium of -13.3-4 = =17.3%!

^should be -17.3%

• That is, security B pays investors 17.3% less than the risk-
free rate.
so security B pays less than risk free asset, why wud u
buy security B when u can earn 4% on the risk free rate

(Why) would investors hold security B?

 Using the Law of One Price for Risky Securities
Example B

• Security B pays off exactly when the investors’ wealth is low and
when the value money the most

• It is not really “risky” from an investor’s point of view

• Instead, they view it as an insurance against the economic

decline
 Risk is relative to the overall market

• The risk of a security cannot be evaluated in isolation.

risk has to be viewed w/ respect to what else is available in the economy

• A security’s risk premium will be higher the more its returns tend
to vary with the overall economy and the market index.

• If the security’s returns vary in the opposite direction of the market

index, it offers insurance and will have a negative risk premium.
security B is only the insurance because you can have other assets, if u only
had security B its risky but w/ respect to other things u get such as ETF, the
bond, then security B becomes an insurance against the market fluctuations
 Historical returns on various asset classes differ considerably

AVERAGE RETURNS ON FINANCIAL AND PHYSICAL ASSETS

Percent p.a. in U$, average over the 1980s

Zero return
in real terms

Source: Malkiel (1996), p. 383

4

there are assets that return negative returns in practice relative particularly to adjust it for
inflation, gold is sth ppl view as insurance asset and traditionally earns u below the risk free rate