9780321818171_berk_ch03

The law of one price implies that if there is another

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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? Solution ◗ Plan The security produces a single cash flow in one year: 0 1 $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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