Problem:
Firms X and Y are identical in all respects except for capital structure. These firms operate in a tax-exempt haven where firms and individuals pay no taxes at all. Current data on the financial structure of the two firms is as follows:
- Firm X: 1,000 shares outstanding, current market price of $10 per share
- 100 bonds outstanding with a current bond price of $100 per bond
- Firm Y: 2,000 shares outstanding, current market price of $9 per share
- 50 bonds outstanding with a current bond price of $100 per bond
The bonds in both firms are risk free and they are zero-coupon bonds that will pay the holder principal and interest one year from today. The risk-free interest rate is 10%. An individual investor can also borrow or lend from a bank at the 10% risk-free rate.
Task:
Question 1: Construct an arbitrage portfolio that includes exactly 100 shares of stock in firm X. How large are the arbitrage profits from this portfolio? Please explain in detail and also provide step by step solution.