Meredith Alvarez is a junior fixed-income analyst with Canzim Asset Management.
Her supervisor, Stephanie Hartson, asks Alvarez to review the asset price and payoff data shown in Exhibit 1 to determine whether an arbitrage opportunity exists. Exhibit 1 Price and Payoffs for Two Risk-Free Assets
Asset Price Today Payoff in One Year
Asset A $500 $525
Asset B $1,000 $1,100
Based on Exhibit 1, Alvarez finds that an arbitrage opportunity is:
A not available.
B is available based on the dominance principle.
C is available based on the value additivity principle.
How come this is the Dominance principle? Please explain this
“The dominance principle asserts that a financial asset with a risk-free payoff in the future must have a positive price today. Because Asset A and Asset B are risk free therefore they should have the same yield but it you calculate it it won’t be same and hence arbitrage opportunity.
But if we take 2 units of Asset A we can see the difference in payoff based on SOTP which is value additivity
Hi, Dhwani can you please elaborate more on this? Still Unsure of why is it dominance instead of value additivity.