Tutorial 2

Finance 1/Business Economics 2

Tamas Barko, Ekaterina Neretina and Emanuele Rizzo1

1 Department

of Finance
Tilburg University

2016

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Outline

Time Value of Money

EX 3.6-3.8

Net Present Value

EX 3.9-3.11

Arbitrage and the Law of One Price

EX 3.1,3.15

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Outline

Time Value of Money

EX 3.6-3.8

Net Present Value

EX 3.9-3.11

Arbitrage and the Law of One Price

EX 3.1,3.15

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?
Having $200 today is equivalent to having 200 1.04 = $208 in one year.

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?
Having $200 today is equivalent to having 200 1.04 = $208 in one year.
(b) Having $200 in one year is equivalent to having what amount
today?

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?
Having $200 today is equivalent to having 200 1.04 = $208 in one year.
(b) Having $200 in one year is equivalent to having what amount
today?
Having $200 in one year is equivalent to having 200 / 1.04 = $192.31
today.

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?
Having $200 today is equivalent to having 200 1.04 = $208 in one year.
(b) Having $200 in one year is equivalent to having what amount
today?
Having $200 in one year is equivalent to having 200 / 1.04 = $192.31
today.
(c) Which would you prefer, $200 today or $200 in one year? Does
your answer depend on when you need the money? Why or why
not?

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Ex 3.6
Interest rates & Time Value

Q: Suppose the risk-free interest rate is 4%.

(a) Having $200 today is equivalent to having what amount in one
year?
Having $200 today is equivalent to having 200 1.04 = $208 in one year.
(b) Having $200 in one year is equivalent to having what amount
today?
Having $200 in one year is equivalent to having 200 / 1.04 = $192.31
today.
(c) Which would you prefer, $200 today or $200 in one year? Does
your answer depend on when you need the money? Why or why
not?
$200 today is better even if you dont need $200 today.
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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?
NPV =

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

NPV =

114
1 + 2%

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

NPV =


114
/110
1 + 2%

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

NPV =


114
/110 1
1 + 2%

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

NPV =


114
/110 1 = $0.016 mln.
1 + 2%

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?

NPV =


114
/110 1 = $0.016 mln. = $16, 000
1 + 2%

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Ex 3.7
Interest rates & Time Value

You have an investment opportunity in Japan. It requires an

investment of $1 million today and will produce a cash flow of 114
million Yen in one year with no risk. Suppose the risk-free interest
rate in the United States is 4%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is 110 Yen per
$1. What is the NPV of this investment? What is the underlying
assumption?



114
NPV =
/110 1 = $0.016 mln. = $16, 000
1 + 2%
Underlying assumption: exchange rate will not change

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Ex 3.8
Interest rates & Time Value

Your firm has a risk-free investment opportunity where it can invest

$160,000 today and receive $170,000 in one year. For what level of
interest rates is this project attractive?

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Ex 3.8
Interest rates & Time Value

Your firm has a risk-free investment opportunity where it can invest

$160,000 today and receive $170,000 in one year. For what level of
interest rates is this project attractive?

$160, 000

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$170, 000
(1 + r )

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Ex 3.8
Interest rates & Time Value

Your firm has a risk-free investment opportunity where it can invest

$160,000 today and receive $170,000 in one year. For what level of
interest rates is this project attractive?

$160, 000

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$170, 000
= r = 170, 000/160, 000 1
(1 + r )

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Ex 3.8
Interest rates & Time Value

Your firm has a risk-free investment opportunity where it can invest

$160,000 today and receive $170,000 in one year. For what level of
interest rates is this project attractive?

$160, 000

Tamas-Katya-Emanuele

$170, 000
= r = 170, 000/160, 000 1 = 6.25%
(1 + r )

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Outline

Time Value of Money

EX 3.6-3.8

Net Present Value

EX 3.9-3.11

Arbitrage and the Law of One Price

EX 3.1,3.15

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Ex 3.9 (a)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(a) What is the NPV of this opportunity?

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Ex 3.9 (a)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(a) What is the NPV of this opportunity?
NPV = PVbenefit PVcost

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Ex 3.9 (a)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(a) What is the NPV of this opportunity?
NPV = PVbenefit PVcost
NPV =

20
5

10
1 + 0.1 1 + 0.1

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Ex 3.9 (a)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(a) What is the NPV of this opportunity?
NPV = PVbenefit PVcost
NPV =

20
5

10 = 18.18 10 4.55 = $3.63 mln.

1 + 0.1 1 + 0.1

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Ex 3.9 (b)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(b) How can your firm turn this NPV into cash today?

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Ex 3.9 (b)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(b) How can your firm turn this NPV into cash today?
t=1

t=2

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Ex 3.9 (b)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(b) How can your firm turn this NPV into cash today?
t=1
borrow $18.18 mln. today
invest $10 mln. in the project
deposit $4.55 mln. in a bank

t=2

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Ex 3.9 (b)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(b) How can your firm turn this NPV into cash today?
t=1
borrow $18.18 mln. today
invest $10 mln. in the project
deposit $4.55 mln. in a bank

t=2
pay back $18.18(1+0.1) from government money
invest $4.55(1+0.1) = $5 mln. in the project

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Ex 3.9 (b)
NPV

You run a construction firm. You have just won a contract to

construct a government office building. Constructing it will take
one year and require an investment of $10 million today and $5
million in one year. The government will pay you $20 million upon
the buildings completion. Suppose the cash flows and their times of
payment are certain, and the risk-free interest rate is 10%.
(b) How can your firm turn this NPV into cash today?
t=1
borrow $18.18 mln. today
invest $10 mln. in the project
deposit $4.55 mln. in a bank

t=2
pay back $18.18(1+0.1) from government money
invest $4.55(1+0.1) = $5 mln. in the project

cash at t = 1: 18.18-10-4.55 = $ 3.63 mln.

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
NPVA = 10 +
= $8.18
(1 + 0.1)

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
5
NPVA = 10 +
= $8.18 NPVB = 5 +
= $9.55
(1 + 0.1)
(1 + 0.1)
10
= $10.91
NPVC = 20
(1 + 0.1)

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
5
NPVA = 10 +
= $8.18 NPVB = 5 +
= $9.55
(1 + 0.1)
(1 + 0.1)
10
= $10.91
NPVC = 20
(1 + 0.1)
(b) If the firm can choose only one of these projects, which should it
choose?

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
5
NPVA = 10 +
= $8.18 NPVB = 5 +
= $9.55
(1 + 0.1)
(1 + 0.1)
10
= $10.91
NPVC = 20
(1 + 0.1)
(b) If the firm can choose only one of these projects, which should it
choose? C

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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
5
NPVA = 10 +
= $8.18 NPVB = 5 +
= $9.55
(1 + 0.1)
(1 + 0.1)
10
= $10.91
NPVC = 20
(1 + 0.1)
(b) If the firm can choose only one of these projects, which should it
choose? C
(c) If the firm can choose any two of these projects, which should it
choose?
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Ex 3.10
NPV

Your firm has identified three potential investment projects. The projects
and their cash flows are shown here:
Project
A
B
C

Cash Flow Today ($)

-10
5
20

Cash Flow in One Year ($)

20
5
-10

Suppose all cash flows are certain and the risk-free interest rate is 10%.
(a) What is the NPV of each project?
20
5
NPVA = 10 +
= $8.18 NPVB = 5 +
= $9.55
(1 + 0.1)
(1 + 0.1)
10
= $10.91
NPVC = 20
(1 + 0.1)
(b) If the firm can choose only one of these projects, which should it
choose? C
(c) If the firm can choose any two of these projects, which should it
choose? C+B
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Ex 3.11 (a)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(a) What is the difference in their offers in terms of dollars today? Which
offer should your firm take?

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Ex 3.11 (a)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(a) What is the difference in their offers in terms of dollars today? Which
offer should your firm take?
S(1): $100, 000 +

$10 10, 000

= $194, 339.62
(1 + 0.06)

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Ex 3.11 (a)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(a) What is the difference in their offers in terms of dollars today? Which
offer should your firm take?
S(1): $100, 000 +

S(2):

$10 10, 000

= $194, 339.62
(1 + 0.06)

$21 10, 000

= $198, 113.21
(1 + 0.06)

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Ex 3.11 (a)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(a) What is the difference in their offers in terms of dollars today? Which
offer should your firm take?
S(1): $100, 000 +

S(2):

$10 10, 000

= $194, 339.62
(1 + 0.06)

$21 10, 000

= $198, 113.21
(1 + 0.06)

S(1) < S(2) = Choose S(1)

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Ex 3.11 (b)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(b) Suppose your firm does not want to spend cash today. How can it
take the first offer and not spend $100,000 of its own cash today?

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Ex 3.11 (b)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(b) Suppose your firm does not want to spend cash today. How can it
take the first offer and not spend $100,000 of its own cash today?
t = 1 borrow $100,000 at 6% from a bank for one year to pay S(1)

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Ex 3.11 (b)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(b) Suppose your firm does not want to spend cash today. How can it
take the first offer and not spend $100,000 of its own cash today?
t = 1 borrow $100,000 at 6% from a bank for one year to pay S(1)
t = 2 pay $206,000

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Ex 3.11 (b)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(b) Suppose your firm does not want to spend cash today. How can it
take the first offer and not spend $100,000 of its own cash today?
t = 1 borrow $100,000 at 6% from a bank for one year to pay S(1)
t = 2 pay $206,000
$106,000 (= $100,000 1.06) pay back to the bank
$100,000 (= $10 10,000) pay to S(1)

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Ex 3.11 (b)
NPV

Your computer manufacturing firm must purchase 10,000 keyboards from

a supplier. One supplier demands a payment of $100,000 today plus $10
per keyboard payable in one year. Another supplier will charge $21 per
keyboard, also payable in one year. The risk-free interest rate is 6%.
(b) Suppose your firm does not want to spend cash today. How can it
take the first offer and not spend $100,000 of its own cash today?
t = 1 borrow $100,000 at 6% from a bank for one year to pay S(1)
t = 2 pay $206,000
$106,000 (= $100,000 1.06) pay back to the bank
$100,000 (= $10 10,000) pay to S(1)
S(1) $206,000 < S(2) $210,000 (= $21 10,000)

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Outline

Time Value of Money

EX 3.6-3.8

Net Present Value

EX 3.9-3.11

Arbitrage and the Law of One Price

EX 3.1,3.15

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Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?

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Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?
Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%.

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Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?
Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%.
b. Which bank would experience a surge in the demand for loans? Which
bank would receive a surge in deposits?

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2016

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Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?
Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%.
b. Which bank would experience a surge in the demand for loans? Which
bank would receive a surge in deposits?
Bank One would experience a surge in the demand for loans, while Bank Enn
would receive a surge in deposits.

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Tutorial 2

2016

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Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?
Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%.
b. Which bank would experience a surge in the demand for loans? Which
bank would receive a surge in deposits?
Bank One would experience a surge in the demand for loans, while Bank Enn
would receive a surge in deposits.
c. What would you expect to happen to the interest rates the two banks
are offering?

Tamas-Katya-Emanuele

Tutorial 2

2016

14 / 15

Ex 3.12
Arbitrage and the Law of One Price

Suppose Bank One offers a risk-free interest rate of 5.5% on both savings
and loans, and Bank Enn offers a risk-free interest rate of 6% on both
savings and loans.
a. What arbitrage opportunity is available?
Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%.
b. Which bank would experience a surge in the demand for loans? Which
bank would receive a surge in deposits?
Bank One would experience a surge in the demand for loans, while Bank Enn
would receive a surge in deposits.
c. What would you expect to happen to the interest rates the two banks
are offering?
Bank One would increase the interest rate, and/or Bank Enn would decrease its
rate.
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2016

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Ex 3.15
Arbitrage and the Law of One Price

The promised cash flows of three securities are listed here. If the cash
flows are risk-free, and the risk-free interest rate is 5%, determine the
no-arbitrage price of each security before the first cash flow is paid.
Security
A
B
C

Tamas-Katya-Emanuele

Cash Flow Today ($)

500
0
1000

Tutorial 2

Cash Flow in One Year ($)

500
1000
0

2016

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Ex 3.15
Arbitrage and the Law of One Price

The promised cash flows of three securities are listed here. If the cash
flows are risk-free, and the risk-free interest rate is 5%, determine the
no-arbitrage price of each security before the first cash flow is paid.
Security
A
B
C

Cash Flow Today ($)

500
0
1000

PVCash Flow of A = 500 +

Tamas-Katya-Emanuele

Cash Flow in One Year ($)

500
1000
0

500
= $976.19
1.05

Tutorial 2

2016

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Ex 3.15
Arbitrage and the Law of One Price

The promised cash flows of three securities are listed here. If the cash
flows are risk-free, and the risk-free interest rate is 5%, determine the
no-arbitrage price of each security before the first cash flow is paid.
Security
A
B
C

Cash Flow Today ($)

500
0
1000

PVCash Flow of A = 500 +

Tamas-Katya-Emanuele

Cash Flow in One Year ($)

500
1000
0

500
1000
= $976.19 PVCash Flow of B =
= $952.38
1.05
1.05

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2016

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Ex 3.15
Arbitrage and the Law of One Price

The promised cash flows of three securities are listed here. If the cash
flows are risk-free, and the risk-free interest rate is 5%, determine the
no-arbitrage price of each security before the first cash flow is paid.
Security
A
B
C

Cash Flow Today ($)

500
0
1000

Cash Flow in One Year ($)

500
1000
0

500
1000
= $976.19 PVCash Flow of B =
= $952.38
1.05
1.05
= $1, 000

PVCash Flow of A = 500 +

PVCash Flow of C

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Tutorial 2

2016

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Ex 3.15
Arbitrage and the Law of One Price

The promised cash flows of three securities are listed here. If the cash
flows are risk-free, and the risk-free interest rate is 5%, determine the
no-arbitrage price of each security before the first cash flow is paid.
Security
A
B
C

Cash Flow Today ($)

500
0
1000

Cash Flow in One Year ($)

500
1000
0

500
1000
= $976.19 PVCash Flow of B =
= $952.38
1.05
1.05
= $1, 000

PVCash Flow of A = 500 +

PVCash Flow of C

While the total cash flows paid by each security are the same ($1000), securities
A and B are worth less than $1000 because some or all of the money is received
in the future.
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2016

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