Scribd
Upload
15 views

PoF Tutorial 1 Solutions

Uploaded by

farhangbak
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
15 views

PoF Tutorial 1 Solutions

Uploaded by

farhangbak
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

Tutorial 1 Solutions for Principles of Finance

1. The no-arbitrage price of a security


(a) In competitive markets, if two different assets have identical cash flows, they should
trade at the same price.1 Therefore, we can determine the no-arbitrage price of the bond in
the question by calculating the price of any other asset that offers £1,000 in one year with
certainty. One such asset is a bank savings account.2 We simply need to find the amount of
deposit needed now, in order to have £1,000 in the account in one year:
£1, 000
𝑃𝑉 = = £952.38
1 + 5%
Because depositing £952.38 in the bank yields £1,000 in one year, and because the newly
issued bond also yields £1,000 in one year, the no-arbitrage price of the bond is £952.38.
(b) The analyst should borrow £952.20 from the bank at 5%, and buy the bond with
this borrowed money. This is because, the bond is trading cheaper than its no-arbitrage price
(£952.20 < £952.38).
At the end of the year, the bond matures and pays £1,000 to the analyst. The analyst
returns the principal amount he borrowed, which is £952.20, and also pays the bank an
interest of 5% × £952.20 = £47.61. As a result, his profit at the end of the year is:

£1, 000 − £952.20 − £47.61 = £0.19

This is arbitrage, since the analyst did not use any of his money, did not take any risks, and
in the end made a profit.
(c) In competitive markets, arbitrage opportunities disappear fast. This means that the
bond’s price should quickly converge to its no-arbitrage price of £952.38.

2. The separation principle


The separation principle states that, in competitive markets, an investment project should
be evaluated on the basis of its net present value (NPV), which does not depend on the way
the investment is financed. Therefore, investment decisions can be separated from financing
decisions.
The NPV of an investment project is simply the difference between the present value of
the benefits brought by the project and the present value of the costs incurred due to the
project:
𝑁 𝑃 𝑉 = 𝑃 𝑉 (𝑏𝑒𝑛𝑒𝑓 𝑖𝑡𝑠) − 𝑃 𝑉 (𝑐𝑜𝑠𝑡𝑠)
1
Otherwise, an arbitrage opportunity arises.
2
We implicitly assume that the deposits in the bank are safe, either because the bank does not face any
risk of bankruptcy, or because the deposits are insured by the state.

1
The NPVs of the entrepreneur’s business ideas (i.e., his investment projects) are:

£2, 200
𝑁 𝑃 𝑉 (𝑖𝑑𝑒𝑎 1) = − £2, 000 = −£18.02
1 + 11%
£5, 600
𝑁 𝑃 𝑉 (𝑖𝑑𝑒𝑎 2) = − £5, 000 = £45.05
1 + 11%
Therefore, even though the entrepreneur has enough wealth to invest in the first idea, he
should not, since this idea yields a negative NPV. The second idea has a positive NPV. Thus,
the entrepreneur should not skip this project just because his wealth does not cover the
investment cost. He should take out a loan of £2,000 from a bank at 11% and repay the bank
(1 + 11%)× £2,000 = £2,220 in one year.
Note that, according to the separation principle, the bank loan should not change the
project’s NPV:
£5, 600 £2, 220
𝑁 𝑃 𝑉 (𝑖𝑑𝑒𝑎 2 𝑤𝑖𝑡ℎ 𝑏𝑎𝑛𝑘 𝑙𝑜𝑎𝑛) = − £3, 000 − = £45.05
1 + 11% 1 + 11%
This is indeed the case: 𝑁 𝑃 𝑉 (𝑖𝑑𝑒𝑎 2 𝑤𝑖𝑡ℎ 𝑏𝑎𝑛𝑘 𝑙𝑜𝑎𝑛) = 𝑁 𝑃 𝑉 (𝑖𝑑𝑒𝑎 2).

3. Mutually exclusive projects


Investment projects have the following NPVs:
£20 £110
𝑁 𝑃 𝑉𝐴 = −£100 + + = £18.82
1.05 (1.05)2

£20 £160
𝑁 𝑃 𝑉𝐵 = −£120 + + = £44.17
1.05 (1.05)2

−£100 £105
𝑁 𝑃 𝑉𝐶 = £0 + + = £0
1.05 (1.05)2

(a) The CEO should invest in projects 𝐴 and 𝐵. He should be indifferent in terms of
investing in project 𝐶, since this project neither creates nor destroys value.
(b) If the projects are mutually exclusive, he should select project 𝐵. This project has
the highest NPV, which means that it is the most value adding project.

4. Carry trade (Adopted from Problem 3.13 in Berk and DeMarzo (2011))
There is exchange rate risk. Engaging in such transactions may incur a loss if the value of
the dollar falls relative to the yen. Because a profit is not guaranteed, this strategy is not an
arbitrage opportunity.

You might also like