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Unformatted text preview: ds. We will show that any financial security can be thought of
as a claim to future cash flows. The Law of One Price implies that if there is another way to
recreate the future cash flows of the financial security, then the price of the financial security
and the cost of recreating it must be the same. Recall that earlier we defined the present
value of a cash flow to be the cost of recreating it in a competitive market. Thus, we have the
following key implication of the Law of One Price for financial securities:
The price of a security should equal the present value of the future cash flows
obtained from owning that security. E X A MPLE 3 .6
Pricing a Security
Using the Law of
One Price Problem
You are considering purchasing a security, a “bond,” that pays $1000 without risk in one year,
and has no other cash flows. If the interest rate is 5%, what should its price be?
The security produces a single cash flow in one year:
$1000 The Law of One Price tells you that the value of a security that pays $1000 in one year is the...
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- Spring '07