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08CashFlowRiskArbitrage-2013.pdf-Another Example • What is ashowing page 18-19 out of 19

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Another Example
What is a fair price for a project whose payoff is
$140 if the market goes up and $30 if the market
goes down?
The risk free rate is 5% for this period
The current MP is priced at $100
If the market goes up, it will be worth $120
If the market goes down, it will be worth $95
If probability of the market going up is 60%, what is
the expected return on the MP? What is the expected
return of the project?
What if the expected payoff of the project was
$120, regardless what the market did?


Page 19
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Summary
Risk is rewarded with greater returns
The “no arbitrage” assumption in finance is
used to help us price
expected
cash flows
MPT and CAPM can be used to determine
appropriate “rewards” for a given risk
For the majority of the course, the expected
return will be given


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