Chapter 3: Arbitrage and Financial Decision Making Flashcards
Competitive Market
by which we mean a market in which it can be bought and sold at the same price
Valuation Principle
- the value of an asset to the firm or its investors is determined by its competitive market price
- the benefits and costs of a decision should be evaluated using these market prices, and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm
Interest Rate
- the amount a lender charges a borrower and is a percentage of the principal—the amount loaned
- determined by the rate at which we can exchange money today for money in the future
- allows us to convert a currency in one point of time to the same currency in another point in time
Risk-free Interest Rate
for a given period as the interest rate at which money can be borrowed or lent without risk over that period
3 Step Cost Benefit Analysis
- identify the costs
- identify the benefits
- compare both
Net Present Value (NPV)
- the NPV of a project or investment is the difference between the present value of its benefits and the present value of its costs
- equivalent to cash today
- = PV (Benefits) - PV (Costs)
- or = PV (All project cash flows)
The NPV Decision Rule
- when making an investment decision, take the alternative with the highest NPV
- accept those projects with positive NPV
- reject those projects with negative NPV
NPV and the Individual’s Consumption Preferences
- separation of the individual’s consumption preferences from the optimal investment decision
- regardless of our preferences for cash today versus cash in the future we should always maximize NPV first
- we can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows
Arbitrage
- the practice of buying and selling equivalent goods in different markets to take advantage of a price difference
- arbitrage opportunity
Arbitrage Opportunity
occurs when it is possible to make a profit without taking any risk or making any investment
Normal Market
a competitive market in which there are no arbitrage opportunities
Law of One Price
if equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets
Financial Security
an investment opportunity that trades in a financial market
Bond
a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment
No-arbitrage Price
in a normal market, when the price of a security equals the present value of the cash flows paid by the security
Separation of the Investment and Financing Decisions
- security transactions in a normal market neither create nor destroy value on their own
- we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering
- the NPV of an investment decision can be evaluated separately from any financial transactions a firm is considering
Value Additivity
a relationship determined by the Law of One Price, in which the price of an asset that consists of other assets must equal the sum of the prices of the other assets
Risk
the chance that an outcome may be different from the expected outcome
Risk Aversion
the notion that investors prefer to have a safe cash flow rather than a risky one of the same expected amount
Return
the difference between the selling price and purchasing price of an asset plus any cash distributions expressed as a percentage of the buying price
Expected (Mean) Return
a computation for the return of a security based on the average payoff expected
Portfolio
collection of securities
Robo-advisors
computer programs that provide detailed and personalized investment advice in place of a financial advisor
