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Finance
LECTURE 2
TOPIC 2: CORPORATIONS AND CAPITAL
MARKETS
Corporations | Ownership vs Control | Capital Markets | Federal
Reserve System | The NPV Decision rule | No-Arbitrage Principle
or The Law of One Price | No-Arbitrage Pricing | Risk Premium
Ownership vs Control
Capital Markets
$10,500
Today
To
Compare
$10,500>$10,300
The
Opportunity
In
Previous
example:
PV($10, 000)
$10, 500
=
$10, 000
1 + 3%
= $194.175 > 0
Thus, our
NPV = PV($15mil)
PV($10mil)
$15mil
=
$10mil
1 + 5%
= $4.286mil > 0
Next Year
Next Year
$10 mil
$0
Next Year
$1000
Next Year
-X
X*(1 + 5%)
This
is an arbitrage opportunity
How
Go
The
Cash
flows:
Assets
Today
Next Year
Save at 5% (-1)
+$952.38
-$1000
T-Bill (+1)
-$940.00
+$1000
Risk-free Profit
+$12.38
$0
No-Arbitrage Pricing
No-Arbitrage Pricing
$1000
$952.38 =
1 + 5%
More generally:
No-Arbitrage Pricing
Today
?
6 months
$10 mil
1 year
$15 mil
Today
6 months
1 year
B1
$970
$1000
B2
$950
$1000
No-Arbitrage Pricing
$10mil
Units of B1 =
= 10, 000
$1000
$15mil
Units of B2 =
= 15, 000
$1000
No-Arbitrage Pricing
Today
6 months
1 year
+B1 (10,000)
-$9.7 mil
+$10 mil
+B2 (15,000)
-$14.25 mil
+$15 mil
Portfolio
-$ 23.95 mil
+$10 mil
+$15 mil
Notice that the bonds portfolio has the same exact payoffs
as asset A
The Market Index has risky payoffs, and its rate of return is
risky as well
1000
= 10%
This
In
RP(Index)
= 10% - 4% = 6%