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1. Suppose Bank one offers a risk free interest rate of 5.5% on both savings and loans, and Bank Enn offers a risk free interest rate of 6% on both savings and loans. What arbitrage opportunity is available? Which bank would experience a surge in the demand for loans? Which bank would receive a surge in deposits? What would you expect to happen to the interest rates the two banks are offering?
2. The promised cash flows of three securities are listed here. If the cash flow are risk free and the risk free interest rate is 5%,determine the no-arbitrage price of each security before the first cash flow is paid.
Security cash flow today($) cash flow in one year($)
A 500 500
B 0 1000
C 1000 0
We can discount cash flows either by using spot rates or forward rates, because a spot rate is simply a package of short-term forward rates. Assume that the cash
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