Essentials Of Investments
11th Edition
ISBN: 9781260013924
Author: Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher: Mcgraw-hill Education,
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Transcribed Image Text:An Exchange Traded Fund (ETF) is a security that represents a portfolio of individual stocks, which can be bought and sold on stock exchanges like individual stocks. This example assumes that the ETF can be exchanged for the underlying stocks and that an ETF unit can be formed using the underlying stocks. Additionally, it is assumed that stocks and ETFs can be purchased and short-sold without any limitations.
**Lonestar ETF Composition:**
- 5 shares of Exxon Mobil (XOM)
- 8 shares of AT&T (T)
- 1 share of Texas Instruments (TXN)
**Current Bid and Ask Prices:**
| Security | Bid Price | Ask Price |
|--------------------------|-----------|------------|
| Exxon Mobil (XOM) | $36.05 | $36.08 |
| AT&T (T) | $28.87 | $28.90 |
| Texas Instruments (TXN) | $156.75 | $156.80 |
| Lonestar ETF | $569.60 | $569.70 |
**Arbitrage Analysis:**
To determine arbitrage opportunities:
1. Calculate the cost of acquiring the underlying stocks at the ask prices:
- Exxon Mobil: 5 × $36.08 = $180.40
- AT&T: 8 × $28.90 = $231.20
- Texas Instruments: 1 × $156.80 = $156.80
- Total cost: $180.40 + $231.20 + $156.80 = $568.40
2. Compare the total cost ($568.40) with the bid price of the Lonestar ETF ($569.60).
The cost of acquiring the underlying stocks is lower than the bid price of the Lonestar ETF, presenting an arbitrage opportunity.
**Arbitrage Strategy:**
- Buy the underlying stocks at their respective ask prices (total = $568.40).
- Simultaneously sell the Lonestar ETF at the bid price ($569.60).
This transaction can earn an arbitrage profit of $1.20 per ETF unit (i.e., $569.60 - $568.40).
If no arbitrage opportunity existed, the combined price of the underlying stocks would equal the ETF's bid price. However, in this case, there is a profit to be made by executing the described transactions.
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