BUSS 207 – Fall 2021: Quiz 3 (Chapter 3) Solution

Use the information for the question(s) below.

Alaska North Slope Crude Oil (ANS) $71.75/Bbl

West Texas Intermediate Crude Oil (WTI) $73.06/Bbl

As an oil refiner, you are able to produce $76 worth of unleaded gasoline from one barrel of Alaska
North Slope (ANS) crude oil. Because of its lower sulfur content, you can produce $77 worth of
unleaded gasoline from one barrel of West Texas Intermediate (WTI) crude.

1) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for
10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you currently have 10,000 Bbls
of WTI crude, the added benefit (cost) to you if you take the trade is closest to:
A) ($1400).
B) $1400.
C) ($3908).
D) $3908.

Total Benefits

No trade and refine WTI crude (base case)

10,000 Bbls × $77 of gasoline/Bbl = $770,000

Trade WTI for ANS crude

10,150 Bbls × $76 of gasoline/Bbl = $771,400

Added Benefits = Total Benefits - Base Case

Trade WTI for ANS crude

= $771,400 - $770,000 = $1400

Section: 3.1 Valuing Decisions

2) You are offered an investment opportunity in which you will receive $25,000 in one year in
exchange for paying $23,750 today. Suppose the risk-free interest rate is 6% per year. Should you
take this project? The NPV for this project is closest to:
A) Yes; NPV = $165
B) No; NPV = $165
C) Yes; NPV = -$165
D) No; NPV = -$165

NPV = -$23,750 + $25,000/1.06 = -$165, since NPV < 0 you should reject project

Section: 3.3 Present Value and the NPV Decision Rule

3) Which of the following statements regarding the Law of One Price is INCORRECT?
A) At any point in time, the price of two equivalent goods trading in different competitive markets
will be the same.
B) One useful consequence of the Law of One Price is that when evaluating costs and benefits to
compute a net present value, we can use any competitive price to determine a cash value, without
checking the price in all possible markets.
C) If equivalent goods or securities trade simultaneously in different competitive markets, then they
will trade for the same price in both markets.
D) An important property of the Law of One Price is that it holds even in markets where
arbitrage is not possible.

Section: 3.4 Arbitrage and the Law of One Price

4) Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE. Walgreen
Company is also listed on NASDAQ and assume it is currently trading on NASDAQ at $48.50. Does
an arbitrage opportunity exist and if so how would you exploit it? How much would you make on a
block trade of 100 shares?
A) No, no arbitrage opportunity exists.
B) Yes, buy on NASDAQ and sell on NYSE, make $25.
C) Yes, buy on NYSE and sell on NASDAQ, make $25.
D) Yes, buy on NASDAQ and sell on NYSE, make $250.

Yes, buy 100 shares × $48.50 and sell 100 shares × $48.75 = $25.00

Section: 3.4 Arbitrage and the Law of One Price

5) Which of the following statements regarding arbitrage and security prices is INCORRECT?
A) We call the price of a security in a normal market the no-arbitrage price for the security.
B) In financial markets it is possible to sell a security you do not own by doing a short sale.
C) When a bond is underpriced, the arbitrage strategy involves selling the bond and investing
some of the proceeds.
D) The general formula for the no-arbitrage price of a security is Price(security) = PV (All cash flows
paid by the security).

Section: 3.5 No-Arbitrage and Security Prices

Use the information for the question(s) below.

An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks.
Consider an ETF for which each share represents a portfolio of two shares of International Business
Machines (IBM), three shares of Merck (MRK), and three shares of Citigroup Inc. (C). Suppose the
current market price of each individual stock are shown below:

Current
Stock Price
IBM $128.92
MRK $71.75
C $64.62

6)The price per share of the ETF in a normal market is closest to:
A) $265.29.
B) $530.58.
C) $666.95.
D) $795.87.
= 2 × $128.92 + 3 × $71.75 + 3 × $64.62 = $666.95

Section: 3.5 No-Arbitrage and Security Prices

7 Suppose that the ETF is trading for $666.95; you should:

A) sell the EFT and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C.
B) sell the EFT and buy 3 shares of IBM, 2 shares of MRK, and 3 shares of C.
C) buy the EFT and sell 2 shares of IBM, 3 shares of MRK, and 3 shares of C.
D) do nothing, no arbitrage opportunity exists.

Value of ETF = 2 × $128.92 + 3 × 71.75 + 3 × 64.62 = $666.95, so no arbitrage opportunity exists

Section: 3.5 No-Arbitrage and Security Prices

8 Suppose a security with a risk-free cash flow of $1000 one year from now trades for $909 today. If
there are no arbitrage opportunities, then the current risk-free interest rate is closest to:
A) 8%.
B) 10%.
C) 11%.
D) 12%.

PV = FV/(1 + i) → (1 + i) = FV/PV = $1000/$909 = 1.10 so i = 10%

Section: 3.5 No-Arbitrage and Security Prices