Fina 5170 Problem Set 7  Fall 2006
Prof. Kensinger  page 1
Arbitrage
Purpose: Arbitrage refers to the activity of buying something in one market and selling
for a profit in another market (today, arbitrage includes buying one thing and selling
another thing that is identical but has a different label). Arbitrage and the arbitrageurs
who conduct this activity are very important for the world’s financial and capital markets,
because their activities keep the markets efficient. The purpose of this problem set is to
provide a small taste of what arbitrageurs do.
The first two problems are warm-ups, to help you adjust to the mindset of an arbitrageur.
There is no magic formula—just common sense and a little basic arithmetic.
1. The following prices are observed. Formulate an arbitrage strategy to profit from the
situation.
o Yen per Dollar exchange rate is 100 spot ($ 1 buys yen 100).
o Pound per Dollar exchange rate is 0.60 spot ($1 buys 60 pence).
o Yen per Pound exchange rate is 200 spot (lb 1 buys yen 200).
2. The following prices are observed. Formulate an arbitrage strategy to profit from the
situation.
o Swiss Franc per Dollar exchange rate is 1.15 spot ($1 buys CHF 1.15).
o Pound per Dollar exchange rate is .40 spot ($1 buys 40 pence).
o Swiss Franc per Pound exchange rate is 2.30 spot (CHF 2.30 buys lb1.00).
Problems 3 and 4 also do not require a magic formula. Again, these just take common
sense and a little basic arithmetic.
3. Suppose that analysts in the mergers and acquisitions department analyzed the
breakup value of BigWorld Corp, which operates BigWorld Airlines, Shug’s
Restaurants, and Betty’s Boutiques. What is the implied market value of the airline?
Is there an arbitrage opportunity here?
o There are 10 million shares of BigWorld outstanding, and the market price is
$100 per share.
o Shug’s Restaurant chain could be sold for $750 million.
o Betty’s Boutiques could be sold for $600 million.
o The airline owns $200 million worth of aircraft, net of all debt.
4. Megalithic Ironworks, Inc. has market value of $100 million. Newton Brickyards,
Inc. has market value of $50 million. Megalithic management decided to acquire
Newton, and paid $100 million for it. Assuming the Value Additivity Principle
holds in this case, what prediction would it lead to?
a. Megalithic stockholders lost $50 million.
b. Newton stockholders lost $50 million.
c. Megalithic stockholders made $50 million.
d. Stockholders of both firms made $50 million.