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KIC000027 - Arbitrage Example Arbitrage Example Suppose...

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Arbitrage: Example Arbitrage: Example • Since the T-note and the two T-bills together give the same future cash flows, an arbitrage opportunity exists if the sum of the T-bill prices differs from the T-note price . • For example, suppose: Pricer .... , = $980,000 Price.moT-bill = $9,500 Price, "T-bill = $970,000 • Then you can profit by • Selling the T-note short and • Buying both T-bills • Suppose aT-note gives the follov.1ng cash flows: Date: Today I 6mo I Iyr I Cashflow: $10,000 51,000,000 • Suppose T-bills exist that give the following cash flows: Date: Today 6mo Iyr I I I i Cashflow: $10,000 Date: Today 6mo Iyr I I , i Cashflow: $1,000,000 Arbitrage Pricing Theory Arbitrage Pricing Theory • The APT posits one or more economic factors (not necessarily a single market factor like the CAPM) that drive security returnS and for which investors must therefore be compensated. But what are the factors? • Factors must be • A pervasive market.wide influence on expected stock returns· (Finn specific events are not APT risk factors-) • Unpredictable.in their.outcome. • Factors may include (but are not limited to): • Unanticipated inflation • Interest rate shock • Unanticipated change in GNP • Unanticipated changes in the default risk premium • The critical property of an arbitrage portfolio is that any
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