Arbitrage and Homemade Leverage

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Arbitrage and Homemade Leverage

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.

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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 FirmToday's Book ValueGood StateBad StateAverage
Debt$0$0$0$0
Unlevered Equity$1,000$1,300$900$1,100
Total Capital$1,000$1,300$900$1,100
Levered FirmToday's Book ValueGood StateBad StateAverage
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 StateBad StateAverage
Arbco's only asset is unlevered firm's equityPayoff 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 FirmToday's Book ValueGood StateBad StateAverage
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 equityProceeds from selling Arbco's equity$550
$500 cash contributed by savvy investorLess 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 StateBad StateAverage
Arbco receives payoff from its loan of $500 + 5% interestPayoff from Arbco's assets$525$525$525
Arbco receives payoff from levered firm's equity$775$375$575
No debtLess 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 FirmToday's Book ValueGood StateBad StateAverage
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 equityProceeds from selling Arbco's equity$1,000
$950 cash contributed by savvy investorLess cost to create Arbco's equity$950
Equals arbitrage profit$50

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