Suppose you live in the Fama-French three-factor model world. Goldman Sachs is selling two derivative...
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Suppose you live in the Fama-French three-factor model world. Goldman Sachs is selling two derivative securities to your company. Both will pay 100 million dollars over a 10 year period. Assume time value of money is zero.
Security A will pay 10 million each year for sure.
Security B will will randomly pay out cash that is unrelated to anything (i.e., there is no correlation with any of the three factors).
| A=100 million because A is risk free; B<100 million because B is risky. | ||
| A=B and both are smaller than 100 million | ||
| A | ||
| B is not risk free but its risk does not matter. So A=B and both are priced at 100 million. |
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