Consider the following table, which gives a security analyst's expectations for return on the market and two well diversified portfolios of cyclical and defensive over the next year, assuming the risk-free rate is 5%: Bust Boom Probability .25 .75 Market Return -4% 20% Cyclical (C) -10% 32% Defensive (D) 2% 14% At least one of the two portfolios is mispriced. Construct an arbitrage strategy with an initial position of $1 (either long or short) in the risk-free asset, to give an arbitrage profit at the end of the year. The arbitrage strategy must not have any position in the market portfolio - you can only hold positions in the risk-free asset, and the cyclical and defensive portfolios. What is the profit per $1 long (or short) the risk-free asset?
Consider the following table, which gives a security analyst's expectations for return on the market and two well diversified portfolios of cyclical and defensive over the next year, assuming the risk-free rate is 5%: Bust Boom Probability .25 .75 Market Return -4% 20% Cyclical (C) -10% 32% Defensive (D) 2% 14% At least one of the two portfolios is mispriced. Construct an arbitrage strategy with an initial position of $1 (either long or short) in the risk-free asset, to give an arbitrage profit at the end of the year. The arbitrage strategy must not have any position in the market portfolio - you can only hold positions in the risk-free asset, and the cyclical and defensive portfolios. What is the profit per $1 long (or short) the risk-free asset?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Consider the following table, which gives a security analyst's expectations for return on the
market and two well diversified portfolios of cyclical and defensive over the next year,
assuming the risk-free rate is 5%:
Bust
Boom
Probability
.25
.75
Market Return Cyclical (C)
-10%
32%
-4%
20%
Defensive (D)
2%
14%
At least one of the two portfolios is mispriced. Construct an arbitrage strategy with an initial
position of $1 (either long or short) in the risk-free asset, to give an arbitrage profit at the end
of the year. The arbitrage strategy must not have any position in the market portfolio - you
can only hold positions in the risk-free asset, and the cyclical and defensive portfolios. What
is the profit per $1 long (or short) the risk-free asset?
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