Question

A security exists that promises to pay $300 in one year’s time.  If the market rate of interest is 20% p.a. and the security is for sale for $200, what would you do and why? Ultimately, what would you expect to happen?

Answer 1

Current Price of Security - $200

Promise to pay in one year - $300

Market rate of Interest - 20% pa

If one is investing $200 and earning 20% interest pa, one will be getting $200 + 20% of $200 after a year.

= 200 + 0.20*200 = $240

So by investing $200 into interest rate instrument we would be getting $240 after a year however if we are investing $200 in a security which is promising to pay $300 after a year, we should in security as returns are way higher in security than the interest rate instrument.

Return on Security is 50% which is ($300 - $200) / $200 = $100/$200 = 50%

While return on interest rate investment is only 20%.

This shows the opportunity of earning by investing into security which will lead to increase in the demand of security with higher demand and low supply hence current price of security will keep increasing unless opportunity from interest rate and security investment matches.

Hope this helps. Thanks and Have a Good Day. Feel free to share your feedback.