QUESTIONS

1. What are the three types of market described in the efficient market hypothesis?
2. In risk-neutral pricing, why is it unnecessary to consider the investor's risk preference?
3. Which interest rate is closer to being risk-free: the one-month Treasury rate or LIBOR?
4. For the following table reproduced from Table 17.3 in the chapter, when calculating the time 1 value of debt, we subtract the value of equity from the value of the firm. Recalculate the debt value based on risk-neutral pricing.

   VALUING DEBT AND EQUITY WHEN DEBT PROMISES TO PAY $99

   

5. Identify at least three factors that would affect a bond's price.
6. Suppose that the current price of a stock is $92 and the expectation is that three months from now the price will be either $95 or $105. Assume that the three-month risk-free interest rate is 2% and that an investor can borrow and lend at that rate.
   1. Assuming that there are no transaction costs, explain why there is an arbitrage opportunity.
   2. Explain how to construct a portfolio to exploit this opportunity.