Harvard Business Publishing strives to make all of its products compliant with accessibility guidelines. The online tool you are using is not screen-readable due its complex and non-linear nature. If you encounter accessibility issues please contact us at: http://hbsp.harvard.edu/list/contact-us. Thank you.
© 2015 Harvard Business School Publishing. Harvard Business Publishing is an affiliate of Harvard Business School.
Arbitrage and Homemade Leverage
Firm Characteristics
In this interactive illustration, the strategy is to manufacture an equity security (either levered or unlevered) and sell it for more than it costs to manufacture it. Set a new market price for the levered firm's equity by entering a value other than $500. Then follow the steps to see how a savvy investor would exploit the arbitrage opportunity.
Enter a value other than $500.
Levered firm's equity is overvalued.
The investor should manufacture levered equity using fairly priced unlevered equity, then sell the levered equity.
Levered firm's equity is undervalued.
The investor should manufacture unlevered equity using underpriced levered equity, then sell the unlevered equity.>
Projected cash flows at the end of one year | |||||
Unlevered Firm | Today's Book Value | Good State | Bad State | Average | |
Debt | $0 | $0 | $0 | $0 | |
Unlevered Equity | $1,000 | $1,300 | $900 | $1,100 | |
Total Capital | $1,000 | $1,300 | $900 | $1,100 |
Levered Firm | Today's Book Value | Good State | Bad State | Average | |
Debt | $500 | $525 | $525 | $525 | |
Levered Equity | $500 | $775 | $375 | $575 | |
Total Capital | $1,000 | $1,300 | $900 | $1,100 |
Begin Arbitrage Steps
Firm Characteristics
Arbco Balance Sheet
The investor manufactures levered firm's equity.
Cash
$1,000
Unlevered Firm's Equity
$1,000
5% interest
–
5% interest
–
5% interest
–
Equity
$500
Equity
$500
Total Assets
$0 $500 $1,000 $1,000
Total Liabilities
and Equity
$0 $500 $1,000 $1,000
Arbco's Payoffs
Payoffs are identical to payoffs from levered firm's equity
Good State | Bad State | Average | |||
Arbco's only asset is unlevered firm's equity | ![]() | Payoff from Arbco's assets | $1,300 | $900 | $1,100 |
Arbco repays $500 + 5% interest | ![]() | Less repayment of Arbco's debt | $525 | $525 | $525 |
– | – | Net payoff to Arbco's equity | $775 | $375 | $575 |
Firm Characteristics
Projected cash flows at the end of one year | |||||
Levered Firm | Today's Book Value | Good State | Bad State | Average | |
Debt | $500 | $525 | $525 | $525 | |
Levered Equity | $500 | $775 | $375 | $575 | |
Total Capital | $1,000 | $1,300 | $900 | $1,100 |
Arbitrage profit is instantaneous and risk-free
Market price of levered firm's equity | ![]() | Proceeds from selling Arbco's equity | $550 |
$500 cash contributed by savvy investor | ![]() | Less cost to create Arbco's equity | $500 |
– | – | Equals arbitrage profit | $50 |
Firm Characteristics
The investor manufactures unlevered firm's equity.
Arbco Balance Sheet
Levered Firm's Equity
$450
5% interest
–
Levered Firm's Equity
$450
Equity
$950
Equity
$950
Equity
$950
Total Assets
$0 $950 $950 $950
Total Liabilities
and Equity
$0 $950 $950 $950
Arbco's Payoffs
Payoffs are identical to payoffs from unlevered firm's equity
Good State | Bad State | Average | |||
Arbco receives payoff from its loan of $500 + 5% interest | ![]() | Payoff from Arbco's assets | $525 | $525 | $525 |
Arbco receives payoff from levered firm's equity | ![]() | $775 | $375 | $575 | |
No debt | ![]() | Less repayment of Arbco's debt | $0 | $0 | $0 |
– | – | Net payoff to Arbco's equity | $1,300 | $900 | $1,100 |
Firm Characteristics
Projected cash flows at the end of one year | |||||
Unlevered Firm | Today's Book Value | Good State | Bad State | Average | |
Debt | $0 | $0 | $0 | $0 | |
Unlevered Equity | $1,000 | $1,300 | $900 | $1,100 | |
Total Capital | $1,000 | $1,300 | $900 | $1,100 |
Arbitrage profit is instantaneous and risk-free
Market price of unlevered firm's equity | ![]() | Proceeds from selling Arbco's equity | $1,000 |
$950 cash contributed by savvy investor | ![]() | Less cost to create Arbco's equity | $950 |
– | – | Equals arbitrage profit | $50 |
ncG1vNJzZmirY2Ourq3ZqKWar6NjsLC5jqGcZpmjqLK1v4ypqaicX567tbHRmpqtoaaawHB9km%2BWmqqSnsGzrcaelqGnnZq6orDEmKOeppSeu6h7q5qsp5uYY7W1ucs%3D