Arbitrage and the Law of One Price

Assume for this problem that markets are frictionless (i.e. no transactions costs and no

short-selling constraints). It's a week before the Cubs-White Sox game and you _nd a

market that sells two securities:

_ CBS Security which pays $1 next week if Cubs win and $0 otherwise; currently trading

at $0.75

_ WS Security which pays $1 next week if White Sox win and $0 otherwise; currently

trading at $0.20

A. What is the risk-free rate if there is no arbitrage? (Do not worry about expressing

this as an annualized percentage.)

Hint: What is the payo_ to the risk-free security if Cubs wins? What is its payo_ if

White Sox win? Can you use the information given above to construct this security?

B. Suppose that the risk-free rate is 2% for a week. (i.e. $1 invested today pays o_ $1.02

in a week.) What strategy would you use to take advantage of this situation?

c. What would you expect to happen if CBS = $0.75, WS = $0.20, and r = 2%? In

particular, would you expect prices to change? If so, how would they change? If not,

why not?