Topic 1: Arbitrage and Financial Decision Making

Question 1

What is the Valuation Principle?

Answer 1

• The benefits and costs of decisions should be evaluated using competitive market prices
• And when the value of the benefits exceeds the value of the costs, the investment decision should be made

Question 2

When the Net Value (NV) is positive….

Answer 2

The value of the benefits exceeds the value of the costs

Question 3

What is a competitive market?

Answer 3

A market in which goods can be bought and sold at the same price

Question 4

What is a risk free interest rate or discount rate rf?

Answer 4

The interest rate at which money can be borrowed or lent without risk.

Question 5

Interest Rate Factor =

Answer 5

1 + rf

• £1 + rf in the future and (vice versa)

Question 6

Discount Factor =

Answer 6

1/(1+rf)

• £1 in the future is worth 1/(1+rf) today and (vice versa)

Question 7

What is the Net Present Value (NPV)?

Answer 7

The NPV of an investment is the present value of its benefits minus the the present value of its costs

Question 8

NPV equation

Answer 8

NPV = PV (benefits) - PV (costs)

Question 9

What is the Net Present Value Decision Rule?

Answer 9

When making an investment decision, take the alternative with the highest Net Present Value

Question 10

Brief of Net Present Value Decision Rule?

Answer 10

• The NPV of not doing a project is zero
• When deciding whether to accept or reject a project, we should accept only if the NPV is positive
• Any positive NPV project will increase the value of the firm
• Use of market prices means this is true regardless of preferences or needs, and regardless of cash availability
• If choosing between different alternative investments/projects, choose the one with highest NPV.

Question 11

What is the Law of One Price?

Answer 11

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

Question 12

What is Arbitrage?

Answer 12

The practice of buying and selling equivalent goods in different markets to take advantage of a price difference.

Question 13

When does arbitrage opportunity occur?

Answer 13

When it is possible to make a profit without taking any risk or making any investment i.e. it its a strategy with a positive NPV

Question 14

What is a normal market?

Answer 14

A competitive market in which there are no arbitrage opportunities

Question 15

What are financial securities?

Answer 15

Investment opportunities that are traded in a financial market, typically using no-arbitrage arguments

Question 16

In a normal market, the following conditions must hold…

Answer 16

No Arbitrage price of a security

Price (security) = PV (All cash flows paid by the security)

Question 17

NOW CONTINUE