Consider two stocks: Stocks Current Price Possible Prices after one year Stock ABC $12.00 ABC + = $13.60 ABC – = $11.20 Stock XYZ $10.00 ABC + = $11.75 ABC – = $8.80 Assume a risk-free borrowing and lending rate is 5.20% and that neither stock pays dicidends, and a fractional shares can be bought and sold. *** Give the same stocks, ABC and XYZ. Suppose you find that there is an arbitrage opportunity involving a forward contract. Let ABC stock sell at $12.00 and that you borrow to buy 1000 shares of stock ABC at 5.20% interest by issuing a risk-free bond. You also entered into a forward contract to sell this share at $14.00 one period later and that you also see an opportunity to engage in the bonds market risk-free. Question: Show that, given a higher or a lower price of ABC and XYZ, is an opportunity to gain profit. Show your complete solution.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Consider two stocks:
| Stocks | Current Price | Possible Prices after one year |
| Stock ABC | $12.00 |
ABC + = $13.60 ABC – = $11.20 |
| Stock XYZ | $10.00 |
ABC + = $11.75 ABC – = $8.80 |
Assume a risk-free borrowing and lending rate is 5.20% and that neither stock pays dicidends, and a fractional shares can be bought and sold.
***
Give the same stocks, ABC and XYZ. Suppose you find that there is an arbitrage opportunity involving a forward contract. Let ABC stock sell at $12.00 and that you borrow to buy 1000 shares of stock ABC at 5.20% interest by issuing a risk-free bond. You also entered into a forward contract to sell this share at $14.00 one period later and that you also see an opportunity to engage in the bonds
market risk-free.
Question: Show that, given a higher or a lower price of ABC and XYZ, is an opportunity to gain profit. Show your complete solution.
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