Suppose initially that two assets, A and B, will each make a single guaranteed p
ID: 1166952 • Letter: S
Question
Suppose initially that two assets, A and B, will each make a single guaranteed payment of $200 in one year. But asset A has a current price of $160 while asset B has a current price of $180. Instructions: Round your answers to 2 decimal places.
a. What are the rates of return of assets A and B at their current prices?
Return on asset A = Return on asset B =
Given these rates of return, which asset should investors buy and which asset should they sell?
Buy asset and sell asset b.
Assume that arbitrage continues until A and B have the same expected rate of return.
When arbitrage ends, will A and B have the same price?
Next, consider another pair of assets, C and D.
Asset C will make a single payment of $300 in one year, while D will make a single payment of $400 in one year.
Assume that the current price of C is $240 and that the current price of D is $360.
c. What are the rates of return of assets C and D at their current prices? Return on asset C =
Explanation / Answer
(a)
Return on asset A = ($200/$160) - 1 = 1.25 - 1 = 0.25 = 25.00%
Return on asset B = ($200/$180) - 1 = 1.1111 - 1 = 0.1111 = 11.11%
(b)
Investment will buy asset A (since it has higher return) and sell asset B (since it has lower return).
When arbitrage ends, assets A and B will not have same price.
(c)
Return on asset C = ($300/$240) - 1 = 1.25 - 1 = 0.25 = 25.00%
Return on asset D = ($400/$360) - 1 = 1.1111 - 1 = 0.1111 = 11.11%