Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Table 2 Strategy Date 0 Cash Flow Date T Cash Flow Long 1 share Stock 750 ST Portfolio Strategy B Borrow e'TtFQT (sift/Fogg- 7E); Total

image text in transcribed
Table 2 Strategy Date 0 Cash Flow Date T Cash Flow Long 1 share Stock 750 ST Portfolio Strategy B Borrow e'TtFQT (sift/Fogg- 7E); Total e'fth'T * 80 ST 7 F031 Because Portfolio A and Portfolio B have the same payoff (at date T), they must have the same cost (price) by Law of One Price (at date 0). Therefore we have F0; : 7777777 (ll in the blank). Suppose now there is a nonrdividendrpaying stock named XYZ with So : $100. The continuously compounded interest rate is 7" : 5% per annum. The arbitragefree forward price of one share of stock XYZ with two years of maturity is 7777777 (ll in the blank). Suppose the above forward contract is traded at $105 per contract (That is, F01 : 105). The rst method of constructing an arbitrage portfolio can be summarized as \"Buy High and Sell Low\". The key to this type of strategy is to construct two portfolios with the same price (at date 0), but different payoff (at date T), with one payoff dominating the other. The arbitrage portfolio involves purchasing the portfolio with higher payo" and selling the portfolio with lower payoff. The cash ow of the above forward contract is summarized as: Table 3 Strategy Date 0 Cash Flow Date T Cash Flow Portfolio A' Long 1 Forward 0 ST 7 105 With the \"correct"7 forward price you calculated above, the cash ow of the portfolio strategy B is as follows (ll in the blank): Table 4 Strategy Date 0 Cash Flow Date T Cash Flow Long 1 unit Stock 7100 ST Portfolio 3' Borrow e'TtFQT 100 Total 0 Note portfolio 3' and portfolio A' have the same price at date 0, yet portfolio A' has a higher payoff at date T. Therefore, we can long the portfolio with higher daterT payoff and short the portfolio with lower daterT payoff (Hence the name Buy High and Sell Low), as follows

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

New Venture Creation A Framework For Entrepreneurial Start-ups

Authors: Paul Burns

2nd Edition

1352000504, 978-1352000504

More Books

Students also viewed these Finance questions

Question

Simplify the expression. Write your answer with (1z)(3+2z4)-2

Answered: 1 week ago