1.5. Financial Decision Making and the Law of One Price

Question 1

Competitive Market

1.
2.
3.

Answer 1

• market in which goods can be bought and sold at the same price
• price then determines the cash value of the good
• value of a good will not depend on the views or preferences of the decision maker

Question 2

What is the Valuation Principle?

1.
2.
3.

Answer 2

• value of an asset to a firm or its investors is determined by its competitive market price!!!! (and not personal preferences)
• benefits and costs of a decision should be evaluated using these market prices (benefits cash inflows and costs cash outflows)
• when the present value of the benefit exceeds the present value of the costs, the decision will increase the market value of the firm

Question 3

Arbitrage

Answer 3

the practice of buying and selling equivalent goods in different markets to take advantage of a price difference without taking any risk (!)

Question 4

Normal Market

Answer 4

is a competitive market in which there are no arbitrage opportunities

Question 5

Law of One Price

Answer 5

if equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets