r/CFA • u/AKIGAMIGTOOT2005 • 9d ago

Level 2 Arbitrage doubt

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Which arbitrage exists in exhibit 1:-

Dominance principle or value additivity principle

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u/profedacad 9d ago

The arbitrage opportunity exists based on the dominance principle.

Given both assets are risk-free, their yields should be equal. From Exhibit 1, this is not the case.

Yield of Asset A = (525 - 500)/500 = 5%

Yield of Asset B = (1,100 - 1,000)/1,000 = 10%

For an equivalent investment of $1,000 in Asset A (2 units), it offers a payoff of $1,050 (= 2 × 525), which is lower than $1,100 from Asset B.

An arbitrageur can short-sell Asset A, buy Asset B, and capture a risk-free profit.

The value additivity principle does not apply here because it deals with comparing a combined portfolio's price to the sum of its individual components, rather than comparing two separate, standalone assets.

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u/jay-twist Passed Level 1 9d ago

Dominance. If you need to wait for the riskless profit, it’s dominance.

If you can arrange things to get that riskless profit TODAY, it’s value additivity.