Suppose the SPY index will either go up 10% or down 10% by the end of next week. In addition, you know that the probability of either case occurring is 50%. The index currently sells for $320. Take these details as facts. An associate at your firm (call him trader A) argues that a bull market is on its way, and that there is in fact a 70% chance of the 10% increase, and a 30% chance of a 10% decrease. A second associate (call him trader B) argues that a bear market is on its way, and that the probabilities are just the opposite; a 30% chance of the 10% increase, and a 70% chance of a 10% decrease. Now suppose trader A catches on and won't trade, leaving only trader B willing to buy and sell at a price equal to their own expected value of the stock price. You have $320 for investment. How much money can you make on a quick arbitrage trade using trader B (and perhaps a short sale)?
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.
Suppose the SPY index will either go up 10% or down 10% by the end of next week. In addition, you know that the probability of either case occurring is 50%. The index currently sells for $320. Take these details as facts.
- An associate at your firm (call him trader A) argues that a bull market is on its way, and that there is in fact a 70% chance of the 10% increase, and a 30% chance of a 10% decrease.
- A second associate (call him trader B) argues that a bear market is on its way, and that the probabilities are just the opposite; a 30% chance of the 10% increase, and a 70% chance of a 10% decrease.
Now suppose trader A catches on and won't trade, leaving only trader B willing to buy and sell at a price equal to their own expected value of the stock price. You have $320 for investment. How much money can you make on a quick arbitrage trade using trader B (and perhaps a short sale)?
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