Question 2

Two economists are walking down the street. One spots a $100 bill on the ground.

"Hey," he says to his friend, "There's a hundred bucks lying on the ground!"

"Don't be silly," the other replies, "If there were a hundred dollars on the ground, someone would have picked it up already!"

The two economists keep walking down the street.

If the bill was real, is this an arbitrage strategy? Explain.

Why the economists decision to keep walking make sense? What is a counter argument to the economists decision?

Consider securities A, B and C below.

	Cost	Recession	Normal	Boom
A	40	50	50	50
B	20	40	20	35
C	30	20	60	35

Bob has come over to eat all your potato chips. He claims that he has uncovered an arbitrage opportunity (aside from the free potato chips). Bob explains that since Asset A is the risk-free asset it has a positive return in every state of the world. This implies, he adds, that since you cannot lose money in any state of the world Asset A is an arbitrage opportunity. Explain to Bob why he is correct or why he is mistaken.

Are the free potato chips Bob is wolfing down really an arbitrage strategy? Discuss.

Using the securities A, B and find at least one arbitrage strategy? Prove that it works.