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Use the information for the question(s) below
Use the information for the question(s) below. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of 2 shares of International Business Machines (IBM), 3 shares of Merck (MRK), and 3 shares of Citigroup Inc. (C). Suppose the current market price of each individual stock is shown below: Stock Current Price IBM MRK $40 $75 $92 ? Suppose that the ETF is trading for $561.00. Assuming there are no transaction costs and no taxes, what arbitrage opportunity is available? O Buy the ETF and sell 2 shares of IBM, 3 shares of MRK, and 3 shares of C. O Buy the ETF and sell 3 shares of IBM, 2 shares of MRK, and 3 shares of C. No arbitrage opportunity exists. O Sell the ETF and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C. O Sell the ETF and buy 3 shares of IBM, 2 shares of MRK, and 3 shares of C.
Expert Solution
Answer:- Buy the ETF & sell 2 shares of IBM, 3 of MRK, 3 shares of C
Let us compute the estimated price of the ETF based on its composition
Estimated Price of ETF = 2 * Share price of IBM + 3 * Share price of MRK + 3 * Share price of C
Estimated Price of ETF = 2 * $40 + 3 * $75 + 3 * $92
Estimated Price of ETF = $581
Actual price of ETF = $561
Estimated Price of ETF > Actual price of ETF
There is an arbitrage opportunity to exploit in the ETF. It can be done by buying(taking a long position) in the ETF & selling(taking a short position) in the ETF constituents i.e 2 shares of IBM, 3 of MRK, 3 shares of C
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