CH08 - 8-1Chapter 8Arbitrage8-2Suppose that a particular...

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Unformatted text preview: 8-1Chapter 8Arbitrage8-2Suppose that a particular stock is selling for $53 on the New York Stock Exchange and simultaneously selling for $50 on the Pacific Coast stock exchange.On arbitrageur can simultaneously buy on the Pacific Coast exchange for $50 and sell on the New York stock exchange for $53.8-3The arbitrageur makes an instant, risk-free profit of three dollars. The ability to repeatedly carry out this transaction will force the prices to be the same in equilibrium.NYSEPACSellBuy+$53-$50=$3.8-4Assumptions for ArbitrageNo transactions costs.No default.The ability to shortsell securities and use the proceeds from the shortsale. This is called unrestricted shortselling.8-5Lender of certificatesSellerShortseller buysLender of certificatesIOUCertificate$Purchase of certificateCertificateReturnIOUShort Position Is EstablishedShort Position Is ClosedShortsellerBuyerSale of certificate$8-6Shortseller must buy back at some future.Profit: Shortsale price > Purchase price.Loss: Shortsale price < Purchase price.Potential shortsale losses have no upper bound, implying shortselling is very risky.8-7Not an issue for bonds because of daily accrued interest.$TimeEx-dividend pointAfter-tax value of dividendsFor stocks, shortsellers must pay dividends to lender of certificates.8-8Shortselling a Bond Equals BorrowingPoints in Time12Cash flows+$82.64-$1008-9Hypothetical Strips PricesPoints in time12$70$100$80$1008-10...
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CH08 - 8-1Chapter 8Arbitrage8-2Suppose that a particular...

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