9780321818171_berk_ch03

The 5 interest rate implies that 105 in one year is

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Unformatted text preview: present value of that $1000 cash flow, calculated as the cash flow discounted at the interest rate. The 5% interest rate implies that $1.05 in one year is worth $1 today. ◗ Execute The present value of the $1000 cash flow is: 1000 in one year 4 1.05 $ in one year 5 $952.38 today $ today Therefore, the price must be $952.38. ◗ Evaluate Because we can receive $1000 in one year for a “price” of $952.38 by simply investing at the interest rate (i.e., $952.38 1.05 $1000), the Law of One Price tells you that the price of the security must equal this “do it yourself” price, which is the present value of its cash flow evaluated using market interest rates. To see why this must be so, consider what would happen if the price were different. If the price were $950, you could borrow $950 at 5% interest and buy the bond. In one year, you would collect the $1000 from the bond and pay off your loan ($950 1.05 $997.50), pocketing the difference. In fact, you would try to do the same thing for as many bonds as possible. But everyone else would also want to ta...
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at University of Arizona- Tucson.

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