Calculate the expected future value if you instead took the $1,000 and invested in the risk-free option for 1 year. Would you prefer to invest in the alternative option, or the risk-free option? Explain. Is there an arbitrage opportunity? Explain.

International Financial Management
14th Edition
ISBN:9780357130698
Author:Madura
Publisher:Madura
Chapter11: Managing Transaction Exposure
Section: Chapter Questions
Problem 35QA
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The bank offers risk-free, annual interest rates of 2%. You come across an alternative investment option costing $1,000 and offering $1,300 after 1 year. This investment has a 15% chance of failure and offering $0.

Calculate the expected future value if you instead took the $1,000 and invested in the
risk-free option for 1 year.
Would you prefer to invest in the alternative option, or the risk-free option? Explain.
Is there an arbitrage opportunity? Explain.
Calculate the risk premium interest rate that will equate the alternative investment
with the risk-free option. Why is the risk premium interest rate different from the
risk-free rate?
Transcribed Image Text:Calculate the expected future value if you instead took the $1,000 and invested in the risk-free option for 1 year. Would you prefer to invest in the alternative option, or the risk-free option? Explain. Is there an arbitrage opportunity? Explain. Calculate the risk premium interest rate that will equate the alternative investment with the risk-free option. Why is the risk premium interest rate different from the risk-free rate?
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