3. (15 pts) Your firm has identified three potential investment projects. The projects and their cash flows are shown as follows. Negative cash flows represent costs, and positive cash flows represent benefits.
Suppose all cash flows are guaranteed and the risk-free interest rate is 5%.
What is the NPV of each project? (5 pts)
NPV of A= -20+35/1.05= 13.33
NPV of B= 8+8/1.05=15.62
NOV of C= 30-20/1.05=10.95 If the firm can choose only one of these projects, which should it choose? (5 pts)
Choose the one with the highest NPV, that is Project B with NPV of 15.62 If the firm can choose any two of these projects, which should it choose? (5 pts)
Choose Project B (NPV of 15.62), and A (13.33)
4. (10 pts) In the 1990s, Japanese interest rates were lower than the US interest rates. Many investors implemented a “carry” strategy where they borrowed in Japan and invested the proceeds in the US. Explain why this strategy is not considered arbitrage.
According to Lecture1 slide 40, an arbitrage opportunity occurs when it is possible to make a profit without taking any risk or making any investment.
In this case, however, the exchange rate is fluctuated, we cannot guarantee the “carry” strategy is always profitable. It is possible that the value of Japanese yen rises (relatively to the value of US dollar), and lead to a loss. Due to the fluctuated exchange rate, the risk of exchange, it is still risky, and cannot be considered as arbitrage.
