Chapter 3 - Arbitrage and Financial Decision Making

7)

You have an investment opportunity in Germany that requires an investment of $250,000 today and will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest in Germany is 6% and the current competitive exchange rate is €0.78 to $1.00. What is the NPV of this project? Would you take the project? A)

NPV = 0; No

B)

NPV = 2,358; No

C)

NPV = 2,358; Yes

D)

NPV = 13,650; Yes

Answer:

C

Explanation:

A)

B)

C)

NPV = -250,000 + (€208,650 / 1.06) × $1.00 / €0.78 = 2358, so since NPV > 0, accept D)

Diff: 3

Topic: 3.3 Present Value and the NPV Decision Rule

Skill: Analytical

Use the table for the question(s) below.

Project| Cash flow today| Cash flow in one year|

"eenie"| -10| 15|

"meenie"| 10| -8|

"minie"| -15| 20|

"moe"| 10| -15|

10)

If the risk-free interest rate is 10%, then of the four projects listed, if you could only invest in one project, which on e would you select? A)

Eenie

B)

Meenie

C)

Minie

D)

Moe

Answer:

A

Explanation:

A)

Eenie has highest NPV

NPV Eenie = -10 + 15 / 1.1 = 3.64

NPV Meenie = 10 - 8 / 1.1 = 2.73

NPV Minie = -15 + 20 / 1.1 = 3.18

NPV moe = 10 - 15 / 1.1 = -3.64

B)

C)

D)

Diff: 2

Topic: 3.3 Present Value and the NPV Decision Rule

Skill: Analytical

11)

If the risk-free interest rate is 10%, then of the four projects listed, which project would you never want to invest in? A)

Eenie

B)

Meenie

C)

Minie

D)

Moe

Answer:

D

Explanation:

A)

B)

C)

D)

Moe has negative NPV

NPV Eenie = -10 + 15 / 1.1 = 3.64

NPV Meenie = 10 - 8/1.1 = 2.73

NPV Minie = -15 + 20 / 1.1 = 3.18

NPV moe = 10 - 15 / 1.1 = -3.64

Diff: 2

Topic: 3.3 Present Value and the NPV Decision Rule

Skill: Analytical

3.4 Arbitrage and the Law of One Price

2)

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. Answer:

D

Explanation:

A)

B)

C)

D)

Diff: 2

Topic: 3.4 Arbitrage and the Law of One Price

Skill: Conceptual

Use the table for the question(s) below.

Consider the following prices from a McDonald's Restaurant:

Big Mac Sandwich| $2.99|

Large Coke| $1.39|

Large Fry| $1.09|

4)

A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a Large Fry. Assume that there is a competitive market for McDonald's food items and that McDonalds sells the Big Mac value meal for $4.79. Does an arbitrage opportunity exists and if so how would you exploit it and how much would you make on one extra value meal? A)

Yes, buy extra value meal and then sell Big Mac, Coke, and Fries to make arbitrage profit of $0.68 B)

No, no arbitrage opportunity exists

C)

Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $1.09 D)

Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $0.68 Answer:

A

Explanation:

A)

Buy value meal and sell Big Mac, Coke and Fries

-4.79 + 2.99 + 1.39 + 1.09 = 0.68 (so arbitrage exists)

B)

C)

D)

Diff: 2...