Chapter 3

Arbitrage and Financial Decision

Making

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Chapter Outline

3.1 Valuing Costs and Benefits

3.2 Interest Rates and the Time Value of Money

3.3 Present Value and the NPV Decision Rule

3.4 Arbitrage and the Law of One Price

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3.1 Valuing Costs and Benefits

• Financial Decision Making and the NPV rule• Using Market Prices to Determine Cash Values • When Competitive Market Prices Are Not

Available

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Example 3.1 Competitive Market Prices Determine Value

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Example 3.1 Competitive Market Prices Determine Value

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Example 3.2 Calculating Cash Values Using Market Prices

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Example 3.2 Calculating Cash Values Using Market Prices

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Example 3.3 When Value Depends on Preferences

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Example 3.3 When Value Depends on Preferences

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3.2 Interest Rates and the Time Value of Money

• The Time Value of Money• The Interest Rate: An Exchange Rate Across

Time

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Example 3.4 Comparing Costs at Different Points in Time

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Example 3.4 Comparing Costs at Different Points in Time

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Figure 3.1 Converting Between Dollars Today and Gold, Euros, or Dollars in the Future

We can convert dollars today to different goods, currencies, or points in time by using the competitive market price, exchange rate, or interest rate.

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3.3 Present Value and the NPV Decision Rule

• Net Present Value • The NPV Decision Rule

– Accepting or Rejecting a Project– Choosing Among Projects

• NPV and Individual Preferences

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Equation 3.1 Net Present Value

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Equation 3.2

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Example 3.5 The NPV Is Equivalent to Cash Today

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Example 3.5 The NPV Is Equivalent to Cash Today

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Table 3.1 Cash Flows of Three Possible Projects

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Table 3.2 Computing the NPV of Each Project

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Table 3.3 Cash Flows from Combining Project B with Borrowing

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Table 3.4 Cash Flows from Combining Project B with Saving

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3.4 Arbitrage and the Law of One Price

• An Old Joke • Arbitrage• Law of One Price

Price of a Bond

• Suppose a bond promises to pay $1,000 a year from now. If the relevant interest rate is 5%, what is the price of the bond?

• What if the bond sells for $940?

• What if the bond sells for 960?

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Table 3.5 Net Cash Flows from Buying the Bond and Borrowing

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Table 3.6 Net Cash Flows from Selling the Bond and Investing

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Equation 3.3 No Arbitrage Price of a Security

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Example 3.6 Computing the No-Arbitrage Price

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Example 3.6 Computing the No-Arbitrage Price