Question

Question 2 Two economists are walking down the street. One spots a $100 bill on the ground. "Hey," he says to his friend, "There's a hundred bucks lying on the ground!" "Don't be silly," the other replies, "If there were a hundred dollars on the ground, someone would have picked it up already!" The two economists keep walking down the street. (a) If the bill was real, is this an arbitrage strategy? Explain. (b) Why the economists decision to keep walking make sense? What is a counter argument to the economists' decision? (c) Consider securities A, B and C below. Cost 40 20 30 Recession 50 40 20 Normal 50 20 60 Boom 50 35 35 Bob has come over to eat all your potato chips. He claims that he has uncovered an arbitrage opportunity (aside from the free potato chips). Bob explains that since Asset A is the risk-free asset it has a positive return in every state of the world. This implies, he adds, that since you cannot lose money in any state of the world Asset A is an arbitrage opportunity. Explain to Bob why he is correct or why he is mistaken. (d) Are the free potato chips Bob is wolfing down really an arbitrage strategy? Discuss. (e) Using the securities A, B and find at least one arbitrage strategy? Prove that it works.

Answer 1

a]

yes, this is an arbitrage strategy because it is a risk-free profit. There is no risk involved in picking up the bill.

b]

No, it does not make sense because the bill is real, and it is lying on the ground to be picked up.

The counter argument is that there are too few people walking down the street, and that is why the bill is still lying on the ground and nobody has picked it up. The economists are the first to notice the bill, and they have chanced upon a risk free profit.

c]

Bob is incorrect. This is not an arbitrage opportunity. Security A still faces interest rate risk, which is the risk of changes in the security price due to changes in interest rates. The table only captures the risk of economic cycles.

Bob is incorrect because investing in a risk-free asset is not an arbitrage opportunity.

d]

It is not an arbitrage strategy because there is the risk of ill health due to eating so many potato chips. There is no such thing as a free lunch, and hence this is not an arbitrage strategy.