Consider a market with two financial assets, both with a term of one year. The assets yield a single pay-out at maturity, depending on whether the market goes up or down. The prices and pay-outs are specified in the following table:
P0 P1(u) P1(d)
Asset (price) (pay-out if up) (pay-out if down)
A 5 6 4
B 9 12 8
(a) Find an arbitrage opportunity in this market.
(b) In which direction will the prices of A and B move as a result of this arbitrage opportunity? Explain.