Chapter 3: Arbitrage and Financial Decision Making

Question 1

Competitive Market

Answer 1

by which we mean a market in which it can be bought and sold at the same price

Question 2

Valuation Principle

Answer 2

• 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

Question 3

Interest Rate

Answer 3

• 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

Question 4

Risk-free Interest Rate

Answer 4

for a given period as the interest rate at which money can be borrowed or lent without risk over that period

Question 5

3 Step Cost Benefit Analysis

Answer 5

1. identify the costs
2. identify the benefits
3. compare both

Question 6

Net Present Value (NPV)

Answer 6

• 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)

Question 7

The NPV Decision Rule

Answer 7

• when making an investment decision, take the alternative with the highest NPV
• accept those projects with positive NPV
• reject those projects with negative NPV

Question 8

NPV and the Individual’s Consumption Preferences

Answer 8

• 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

Question 9

Arbitrage

Answer 9

• the practice of buying and selling equivalent goods in different markets to take advantage of a price difference
• arbitrage opportunity

Question 10

Arbitrage Opportunity

Answer 10

occurs when it is possible to make a profit without taking any risk or making any investment

Question 11

Normal Market

Answer 11

a competitive market in which there are no arbitrage opportunities

Question 12

Law of One Price

Answer 12

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

Question 13

Financial Security

Answer 13

an investment opportunity that trades in a financial market

Question 14

Bond

Answer 14

a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment

Question 15

No-arbitrage Price

Answer 15

in a normal market, when the price of a security equals the present value of the cash flows paid by the security

Question 16

Separation of the Investment and Financing Decisions

Answer 16

• 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

Question 17

Value Additivity

Answer 17

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

Question 18

Risk

Answer 18

the chance that an outcome may be different from the expected outcome

Question 19

Risk Aversion

Answer 19

the notion that investors prefer to have a safe cash flow rather than a risky one of the same expected amount

Question 20

Return

Answer 20

the difference between the selling price and purchasing price of an asset plus any cash distributions expressed as a percentage of the buying price

Question 21

Expected (Mean) Return

Answer 21

a computation for the return of a security based on the average payoff expected

Question 22

Portfolio

Answer 22

collection of securities

Question 23

Robo-advisors

Answer 23

computer programs that provide detailed and personalized investment advice in place of a financial advisor