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Homework #5
1. In finance, what does one mean by the term “arbitrage”? The article does not define it so
feel free to Google it but you have to give the answer in your own words. A copy-paste job will
get you zero points for this part.
In finance, and arbitrage is the simultaneous buy and sell of an asset in order to take advantage of
price differences and turn an immediate profit on the asset.
2. Describe how Miller explains the proof of MM I using the no-arbitrage principal in this
article. Do not copy-paste Miller’s words, describe in your own words.
By applying the “law of one price”, the opportunity for arbitrage will be eliminated.
3. Miller lists many objections people have raised since 1958 on his work with Modigliani
and answers them each with counter-arguments. In your own words, describe the points of
criticism of MM I that Miller mentions in the first 11 pages of this article. Also explain in your
own words how he refutes them.
How could a firm be indifferent in choosing capital structure when spreads were so high (in that
time)? He answered by showing that it was a wash between the gains from the cheaper debt
capital and the higher cost of the resulting more risky equity capital.
While his principles were theoretically possible, would they hold up to practical real world
application in a real world market? He answered this by introducing a theory of “risk class” and
the “dividend invariance proposition”, then examining arbitrage from the perspectives of
individual, corporate and variations of liability. Used in conjunction with MM1 and MM2, this
framework allowed him to show how what was at the time theory, would actually perform in a
real world market given fluctuation. This was not without its flaws of practicability though, as
introduction of an “information equilibrium” contributed transparency to the driving forces in
dividend decisions by management.
