International finance - Essay Example

The above computation ignores certain other costs usually associated with arbitrage. The first of these is the cost of risk associated with the proposed trading. This risk arises as a result of the possibility of price fluctuations leading to lower realization in the selling market. However, in this case, we are justified in ignoring this risk for the following reasons: The distance between the two markets is stated to be 40 Km, which with modern transportation systems can be covered in less than one hour.

It is reasonable to assume that intra-day fluctuations in cabbage prices in either of the towns will not be very large. Since the item is a perishable one with a limited shelf life of about two weeks, the time factor is not very significant and no premium needs to be added for keeping the material in stock for a long period of time. A zero coupon bond is one that bears no interest. If $20,000 is invested in such a bond maturing ten years from now, and the interest rate is 6% p.a., the present value of the bond can be computed by discounting the maturity value over a period of ten years at the cost of capital, which in this case can be assumed to be the prevailing interest rate.

The present value of a cash inflow of $20,000 ten years hence at a discount rate of 6% is given by the formula: An index linked bond is one in which the capital amount to be repaid is increased every year by the index value and each year’s interest is calculated at the adjusted capital value. Inflation rate is given to be 2% over the last three years. This means that £100 invested three years earlier would have become respectively £102, £104 and £106 respectively over a period of three years.

In the given problem, the £100 bond pays an interest at the rate of 1% of the indexed capital sum at the end of each year. This means that the interest for the first year would be calculated on £102 at the end of the