4 Arbitrage Time Value

4 Arbitrage Time Value - Click to edit Master subtitle...

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Click to edit Master subtitle style Arbitrage, Financial Decisions and The Time Value of Money 11
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Learning Objectives Law of One Price, Equilibrium and Arbitrage What is the relationship between prices at different locations l Prices and Rates Where do we get interest rates from? l Annualizing Rates – APR and EAR How do we annualize rates? l NPV and IRR 22
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Law of One Price In a perfect market (the absence of frictions/transaction costs, market barriers, taxes, etc.), the same good will sell for the same price in two different locations. Because of arbitrage Buy at low price location and re-sell at high price location to make arbitrage profit Or, buyers will simply go to the lower cost seller and sellers will sell to the person offering the highest price. These market forces will eliminate price differences. l If a pair of shoes trades at one location for $100, it must 33
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Equilibrium How are prices of goods determined? Demand and Supply 44
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Buying and Selling Prices: 55 D S Quant ity Pri ce P 0 Q 0 Q 1 Supply curve Demand Curve P 1
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Equilibrium At any given price for a good, there will be some number of individuals who will be willing to buy the good (demand the good). l This number will increase as the price drops. l The [price, demand quantity] pairs gives us the demand schedule (or curve), D. l Similarly, at any given price, there will be some number of individuals willing to sell the good (supply the good). l This number will increase as the price 66
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Prices with frictions Let’s suppose that there are operational costs of trading, e.g., if selling a good requires an incremental cost – let’s assume that this cost can be converted into a per unit value of $1, then the seller would not be willing to sell at the same price as his/her buying price. l If the buying (ask) price is $10, then the selling (bid) price will be $10 + $1 = $11. l There will be no arbitrage profit to make as long as the “one price” falls within the bid- 77
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Financial Assets What is an asset? A financial asset is one that generates future cashflows. In finance, we treat these cash flows as the only relevant characteristic of an asset. l One of the simplest assets is a savings account, whereby a depositor is investing or lending money to the bank. l From the bank’s perspective, they are borrowing money from the depositor, so this appears as a liability on the bank’s balance sheet. 88
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Interest Rates Time Value of Money Consider an investment opportunity with the following certain cash flows. Cost: $100,000 today Benefit: $105,000 in one year The difference in value between money today and money in the future is due to the time value of money.
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Interest Rate: The Price or The rate at which we can exchange money today for money in the future is determined by the interest rate . Suppose the current annual interest rate is 7%. By
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This note was uploaded on 04/04/2011 for the course MBA 648 taught by Professor Jake during the Spring '11 term at Pace.

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4 Arbitrage Time Value - Click to edit Master subtitle...

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