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. Is there an arbitrage opportunity? Explain.Calculate the risk premium interest rate that will equate the alternative investmentwith the risk-free option. Why is the risk premium interest rate different from therisk-free rate?

Arbitrage opportunity arises when there exists a difference between the prices of similar item in…

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?

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?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter20: Financing With Derivatives

Section: Chapter Questions

Problem 4QTD

See similar textbooks

Related questions

Q: How is the risk-adjusted discount-rate approach more commonly practiced in the real world?

A: Risk adjusted discount rate approach is an approach which is used in assessment of various long-term…

Q: Explain the Opportunistic Investing strategies?

A: Opportunistic investing strategies are strategies that involve investment in highly risky…

Q: How do margin trades magnify both the upside potential and the downside risk of an investment…

A: Margin trades refer to the trades in which an investor does not need to pay the full amount to take…

Q: If a security is underpriced (i.e., intrinsic value > price), then what is the relationship…

A: Intrinsic value of a security is the fair value based on the assessment of its fundamentals and…

Q: What does vega measure? What can you tell from vega value? Can the vega of a derivatives portfolio…

A: Option gives right to buy or sell an underlying asset to the buyer of the option at strike price. A…

Q: Explain clearly what should happen to a security’s nominal interest rate as the security’s liquidity…

A: A yield curve is a graph that compares the yields (interest rates) of bonds with similar credit…

Q: How is the call option price impacted by varying the risk free rate of interest? How is the call…

A: 1) Call option is the contract according to which the buyer of the option has the right but not the…

Q: How would the risk premium work out for a riskier investment?

A: A risk premium is a return on venture over the hazard free rate a financial specialist requires to…

Q: In what circumstances would you use one of the available risk measurements used in Modern Portfolio…

A: Modern portfolio theory refers to the theory of investment that allows the investors for…

Q: Critically discuss the effect of diversification on portfolio risk. Is there any limit of…

A: A portfolio is the mixture of securities managed by the portfolio manager. We can take the amount in…

Q: Evaluate the criticism that futures markets siphon off capital from more productive uses.

A: Future contracts are derivative instruments which are used for hedging the exposure of increase or…

Q: In a qualitative analysis, what factors affect the value of a real option?

A: An alternate choice that is accessible to the organization's managers taking investment…

Q: What is the y risk-free investment?

A: Risk-free rate of return is the rate of return that an investor expects from an investment in any…

Q: ) What does the single index model estimate? B) What is the market risk premium? C) What does Beta…

A: A single index model simplifies security analysis by estimating the expected return on security…

Q: What is the constrained portfolio method or portfolio optiomatization? Why would an investor prefer…

A: Diversified portfolio- It refers to a portfolio of investments in which unsystematic risk or firm…

Q: According to the Black-Scholes formula, what will be the hedge ratio (delta) of a put option for a…

A: Black-Scholes formula as follow: C0= current value of call option S0= current market value of the…

Q: Why would an investor prefer a constrained portfolio optimization approach?

A: Portfolio optimization is nothing but a system in which a shareholder provides the correct advice on…

Q: Which of the following will NOT increase the value of a real (call) option?

A: The following does not increase the value of the real (call) option: An increase in the probability…

Q: Explain the Contrarian Investing Strategy?

A: An investment strategy is a procedure to select the best investment portfolio that gives the maximum…

Q: Briefly describe what an investment timing option is and why such options are valuable.

A: There are various time arises where the company need to choose between in order to make the…

Q: What kind of investment is considered to be risk-free?

A: A risk-free investment is an investment that has a minimum or no fluctuation from the expected…

Q: What is definitions of this? Systematic risk  Risk free rate of return  Market rate of…

A: Capital asset pricing model (CAPM) can be used to compute the return expected by the investors by…

Q: How does the diversification of an investor’s portfolio avoid risk?

A: Portfolio investments mean investments in the group of assets, securities, bonds, etc. Investments…

Q: Why is the t-bill's return independent of the state of the economy? Do t-bills promise a completely…

A: Treasury bills (T-bills) are a kind of short-term debt that is issued by the government with the aim…

Q: How the risk and return trade-off can be applied in real life?

A: The risk-return tradeoff states that the return rises with an increase in risk. Investors use this…

Q: Is it true that the the wider the risk premium, the lower the price of a expected future cash flow?

A: Risk premium is the return the stock gives over the risk free asset. risk premium = Rs-Rf Wider risk…

Q: Differentiate between “buying a security on a margin” and “selling a security short”. When would an…

A: Buying assets on margin, also known as margin trading, is putting up collateral, usually with your…

Q: Does a risky investment always equal a big payoff and vice versa?

A: Risky investments are played by risky people only. Lets take an example for better understanding. Mr…

Q: a. It is not possible to invest to the right of the optimal risky portfolio b. Borrow and invest in…

A: The capital market line is the capital allocation line formed when the risky asset is a market…

Q: What is the relationship between forward rates and the market’s expectation of future short rates?…

A: Forward rate implies the yield on the bond expected by investors in future. It is the calculated…

Q: ich of the following inputs is not required to price option using the Black‐Scholes model? a) the…

A: Introduction: The Black-Scholes model is a differential equation used in financial theory. The…

Q: What effect does Risk-free rate have on call option price?

A: Risk-free rate is the rate of return from an investment having no risk or zero risk. In other words,…

Q: Explain what is meant by beta. What risk does beta measure? What is the market return? How is the…

A: Beta is measure of risk and volatility of stock.

Q: What are the trade-offs facing an investor who is considering buying a put option on an existing…

A: Purchasing a put option on an existing portfolio means insuring the portfolio from the downside…

Question

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.

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?

Expert Solution

This question has been solved!

Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.

SEE SOLUTION Check out a sample Q&A here

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step by step

Solved in 6 steps with 4 images

SEE SOLUTION Check out a sample Q&A here

Knowledge Booster

Learn more about

Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.

Similar questions

What is a financial option? What is the single most important characteristic of an option?
What type of security can be used to minimize both price risk and reinvestment riskfor an investor with a fixed investment horizon? Does this security protect the realpayoff? Explain.
How is the call option price impacted by varying the risk free rate of interest? How is the call option price impacted by varying the volatility?
How would the risk premium work out for a riskier investment?
Explain the following three variables which influence the overall rate of return on alternative investments: The real risk-free rate of return The nominal risk-free rate of return The risk premium on the investment
“Even in an efficient market, it is still valid to seek out a ‘favourable’ rate of returnfrom an equity investment. In an efficient market, one security is as good as any other.”Do you agree with this statement? Discuss your point of view.
Explain why the following statement is true: In general, the more uncertainty thereis about future market conditions, the more attractive an investment timing optionwill be, other things held constant.
Evaluate the following statement: If CAPM (Capital Asset Pricing Model) holds, the expected return from a lottery must be equal to the risk-free rate.
Which of the following will NOT increase the value of a real (call) option? Group of answer choices: A decrease in the probability that a competitor will enter the market of the project in question. An increase in the risk-free rate A decrease in the cost of obtaining the real option Lengthening the time in which a real option must be exercised. A decrease in the volatility of the underlying source of risk.