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# S1 - HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT...

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H AAS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT BERKELEY UGBA 103 S UMMER 2008 A VINASH V ERMA S OLUTION TO H OMEWORK 1 + G RADING P OLICY F OR EACH PART , THE CREDIT DEPENDS MAINLY ON DEMONSTRATION OF CONCEPTUAL UNDERSTANDING . T HEREFORE IF A PARTICULAR PART OF THE QUESTION HAS BEEN CORRECTLY SET UP , YOU WILL GET ENTIRE CREDIT FOR THAT PART EXCEPT ONE POINT . O NE POINT IS RESERVED FOR GETTING THE RIGHT NUMERICAL ANSWER . Y OU WILL NOT BE PENALIZED FOR YOUR ERRORS TWICE . T HUS , IF YOU MADE AN ERROR IN PART ( i ), AND USED THAT ERRONEOUS ANSWER AS AN INPUT TO PART ( ii ), YOU WILL NOT BE PENALIZED AGAIN SO LONG AS PART ( ii ) WAS SET UP AND ANSWERED CORRECTLY OTHERWISE . 1. Ms. Juanita Fotheringay-Murgatroyd has \$450,000 available to invest. The three-year spot interest rate, or, more precisely, the rate of interest available now in the market for risk free investments with a term to maturity of three years, is 14.4% per year. A similarly defined five-year spot interest rate is 5.85% per year. (i). Determine whether or not there are risk free arbitrage opportunities here. Give reasons. Yes, there are arbitrage opportunities because the relationship between Discount Factors is violated: DF 3 = 1/1.144 3 = 0.6679; DF 5 = 1/1.0585 5 =0.752568. 20 Points (ii). Set up an arbitrage table to show how arbitrage profits could be realized. Lending \$450K in 3 year markets, we will get \$450K*1.144 3 = \$673,737.29. If we roll this over for 2 years, we will have this amount and the unknown interest, . We can borrow at 5.85% per year PV 0 (\$673,737.29) = \$673,737.29/1.0585 5 =\$507,033.06 in the five-year markets. We make a profit of \$38,070.65 in the process Cash flow at t =0 Cash flow at t =3 t =5 Lend \$450K in 3-yr markets

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S1 - HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT...

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