A McDonalds Happy Meal comprises a hamburger, small fries, small milk shake and a toy. How much should a Happy Meal cost? Answer the following: What practical impediments are there to using absence of arbitrage valuation to price the Happy Meal? What does this tell you about the shortcomings involved with using absence of arbitrage arguments?
Question 1 solution
MacDonald’s has always strived to provide happy meals for three dollars. At $3 the happy meal was originally meant for kids. This, however, is an excellent starter for a larger meal. For adults, a happy meal is recommended alongside another dollar menu item like a McNuggets or Bacon cheeseburger.
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Practical impediments to using the absence of arbitrage valuation to price the happy meals
Absence of arbitrage at happy meals is a situation whereby all meals have been priced appropriately. This means an individual cannot gain by outgaining market gains without taking in a bigger risk or loss. At $3 the happy meal is already priced low and John Cochrane cannot make a profit. Absence of arbitrage exists in situations whereby the asset is considered risk free. The potions in the happy meals are small. Combining two happy meal potions would amount to $6. To counter this, there are additional options that have been priced $1 and $ 2 each. The only way that john Cochran would profit from arbitrage would be a situation when there is a market inefficiency. For instance, if a particular dinner was unable to meet its demand, he can quickly get the happy meal at another location and probably sell at $4. However, McDonald's is big business sand they would quickly correct this situation and John would only profit from the anomaly for a short period.
Shortcoming involved with using arbitrage arguments.
One major shortcoming in this scenario is a large amount of data that is required to be processed while looking for an opportunity. For John to be able to make that quick profit he has to sit out wait for a market anomaly to occur which is not a common event. Besides, the source of the data john is using has to be very accurate lest he makes a loss in the process.
Question 2
BP and Royal Dutch Shell are surely affected by a set of common economic factors, most notable the oil price. Explain whether you think that this means that an arbitrage relationship exists between the two companies. Justify answer
Solution
I believe that the arbitrage relationship exists between the two companies in unique circumstances. Justification.
It suits unanticipated changes.
Both companies operate in environments where there are very few chances for surprises. However, with the current heated geopolitical environments that sudden price spikes can happen allowing for either to happen. For instance, a small country in the Caribbean can where say BP operates can experience a shortage in supply of oil due to breaking down in a ship carrying the crude oil from the gulf. However, Royal Dutch Shell has a ship close by that offload some of its cargo to ease the shortage. Bp would buy that oil and at a slightly higher price guarantying Royal Dutch shell a profit, and due to increase in prices in that small country, Bp would recoup this money by selling at a higher price.
Both are actively looking for arbitrage opportunities.
The oil business requires substantial investments and oil prices have been low in the recent few years. Therefore, it is in the best interest of both companies to be actively sourcing for arbitrage opportunities (Lowenstein, 2002). These opportunities are immediately reflected in the books as a profit from investment activities.
There are no restrictions.
Both Royal Dutch Shell and Bp are in the oil business where each company has data on each other. When an opportunity for arbitrage arises, there will be fewer restrictions to both companies doing business with one another. They are fewer restrictions to the type of information available allowing each side to make market predictions. This makes arbitrage pricing more dependable than competitive pricing in such situations.
References
Lowenstein, R. (2000). When genius failed: The rise and fall of Long-Term Capital Management
