Sign In Sign Up Ask an AI advisor
cpcoolestkid4
cpcoolestkid4
12.03.2021 • 
Business

Consider the following data for a one-factor economy. All portfolios are well diversified. Portfolio E(r) Beta

A 12% 1.2

F 6% 0.0

Suppose that another portfolio, portfolio E, is well diversified with a beta of .6 and expected return of 8%. Would an arbitrage opportunity exist? If so, what is the arbitrage strategy?

When beta = 0, there is no risk, so it is risk free

Since beta = 0, the expected return for Portfolio F equals the risk-free rate

For Portfolio A, the ratio of risk premium is (12% – 6%)/1.2

.12 - .06/1.2 => .06/1.2 = .05 x 100 = 5%

For Portfolio E, the ratio is lower at (8% – 6%)/.6

.08 - .06/.6 => .02/.6 = .0333 x 100 = 3.33%

This implies that an arbitrage opportunity exists

Please explain to me why an arbitrage opportunity exists

Find out weight for Portfolio G:

W1: Weight in Portfolio A

W2: Weight in Portfolio G

W2 = 1 – W1

W1 B1 + (1 – W1)B2 = .6

W1 1.2 + (1 – W1)0 = .6

1.2W1 + 0 = .6

1.2W1 = .6

W1 = .6/1.2 = .5

Expected Return and Beta of Portfolio G:

E(rG) = (.5 x 12%) + (.5 x 6%)

E(rG) = (.5 x .12) + (.5 x .06)

E(rG) = .06 + .03 = .09 x 100 = 9%

βG = (.5 x 1.2) + (.5 x 0)

βG = .6 + 0 = .6

Comparing Portfolio G to Portfolio E, G has the same beta, but a higher expected return than E. Therefore, an arbitrage opportunity exists by buying Portfolio G and selling an equal amount of Portfolio E. The profit for this arbitrage will be:

rG – rE = [9% + (.6 x F)] – [8% + (.6 x F)] = 1%

1% of the funds (long or short) in each portfolio

I believe the answer is correct, but I would like to know why an arbitrage opportunity exists. Explain that to me in relation to the problem and please solve this step by step to get 1% rG – rE = [9% + (.6 x F)] – [8% + (.6 x F)] = 1%

Solved
Show answers

Ask an AI advisor a question

I want advice