Financial Risk Manager Part 1
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As an analyst, you are analyzing a number of stocks of German Tech companies trading on the TecDAX. You come across two stocks DESolars AG and GERTech Co., with expected returns of 4.9% and 5.1%, respectively. In order to assess if an arbitrage opportunity exists between two stocks, you compile the following data to be used in the two-factor model:
Actual GDP Growth: 2% Expected GDP Growth: 2% Actual CPI: 1.7% Expected CPI: 1.5% DESolars (GDP) beta: 1.1 DESolars (CPI) beta: 0.9 GERTech (GDP) beta: 1.1 GERTech (CPI) beta: 0.9
Considering the given data, identify which of the following statement is true?
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TTanishq
A
An arbitrage opportunity does not exist because both stocks have different expected returns.
B
An arbitrage opportunity exists because both firms have the same beta factor.
C
An arbitrage opportunity does not exist because both firms have the same beta.
D
An arbitrage opportunity exists because both firms have different returns for the same systematic risk.
Explanation:
Explanation
An arbitrage opportunity exists because both firms have different returns for the same systematic risk. Arbitrage opportunities arise when there is a discrepancy between the price of a security and its intrinsic value. In this case, both DESolars AG and GERTech Co. have the same systematic risk, as indicated by their identical beta values. However, they offer different returns. DESolars AG has an expected return of 4.9%, while GERTech Co. offers a higher return of 5.1%. This difference in returns for the same level of risk indicates an arbitrage opportunity. An investor could exploit this by short selling the lower-return stock (DESolars AG) and using the proceeds to buy the higher-return stock (GERTech Co.). This would allow the investor to pocket the difference in returns (0.2%) as risk-free profit.
Choice A is incorrect. The existence of an arbitrage opportunity is not determined by whether the stocks have different expected returns. Two stocks can have different expected returns but still not present an arbitrage opportunity if their risk-return profiles are in line with each other.
Choice B is incorrect. The presence of an arbitrage opportunity does not solely depend on both firms having the same beta factor. While it's true that identical betas suggest similar systematic risk, this doesn't automatically imply an arbitrage opportunity unless there's a discrepancy in their returns given this same level of risk.
Choice C is incorrect. Similar to Choice B, the fact that both firms have the same beta does not necessarily mean there isn't an arbitrage opportunity. An arbitrage situation arises when there's a possibility to make a risk-free profit due to price discrepancies for equivalent risks and returns, which isn't directly related to whether or not two firms share identical betas.
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