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Pre-Mid Assignment 2
Corporate Finance
Section: A
Course instructor: Ma’am Fizza Abbas
Date of Submission: 8thO October, 2019
Submitted by:
ZOHRAH RIAZ
BSc. Accounting & Finance
Fall Semester V
F17BACT021
Arbitrage Process
Arbitrage is the process of exploiting differences in the price of an asset by simultaneously
buying and selling it. In the process the arbitrageur pockets a risk-free return. Differences in
prices usually occur because of imperfect dissemination of information.
Only large institutional investors and hedge funds are capable of taking advantage of arbitrage
opportunities. Because they're able to trade large blocks of shares, they can pocket millions in
arbitrage profits even if the spread between two security prices is small (and it usually is just
pennies).
By contrast, individual investors typically don't have the large sums of money needed to take
advantage of arbitrage opportunities, and trading fees would eat up any profits an individual
arbitrageur hoped to secure. Institutional investors aren't burdened by these same limitations.
Of course, small investors and entrepreneurs take advantage of much smaller arbitrage
opportunities every single day. For example, if you've ever purchased a bargain-priced item at a
garage sale or flea market, and then sold that item for a higher price on eBay, then you've
profited from a form of arbitrage.
The main creator of arbitrage opportunity used to be a lack of real-time communication about
prices in other markets, but modern technology has reduced the number of arbitrage
opportunities out there. The relatively few arbitrage opportunities that do exist are elusive and
don't last for long -- when people realize that a security is cheaper in one market than another,
their interest in exploiting the opportunity will drive up the price of the "cheap" security and
drive down the price of the "expensive" security until there is no longer a price difference. In this
manner, arbitrage does a good job of ensuring equilibrium in the markets.
1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of
the firm (V) remains constant. This means that it is independent of the capital structure.
The total value can be obtained by capitalizing the operating earnings stream that is
expected in future, discounted at an appropriate discount rate suitable for the risk
undertaken
2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a
premium for financial risk. This is equal to the difference between the pure equity
capitalization rate and ki times the debt-equity ratio.
3. The minimum cut-off rate for the purpose of capital investments is fully independent of
the way in which a project is financed.
Assumptions of MM approach:
Limitations of MM hypothesis:
For example, if Company XYZ's stock trades at $5.00 per share on the New York Stock
Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an
arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 --
pocketing the difference of $0.05 per share.
Theoretically, the prices on both exchanges should be the same at all times,
but arbitrage opportunities arise when they're not. In theory, arbitrage is a riskless activity
because traders are simply buying and selling the same amount of the same asset at the same
time. For this reason, arbitrage is often referred to as "riskless profit."
Numerical Example:
= 0.184 or 18.44%
You should:
• 1. Sell the stock in Company Arden for $400.
• 2. Borrow $300 at 10% interest (equals 1% of debt for Company
Arden).
• 3. Buy 1% of the stock in Company Wannabee for $666.67. This
leaves you with $33.33 for other investments ($400 + $300 - $666.67).