Final answer:
An arbitrager can potentially exploit a discrepancy between the firm's total asset value and the combined market value of its debt and equity securities to earn a risk-free profit by buying up all the securities and liquidating the company's assets.
Step-by-step explanation:
An arbitrager reviewing the pricing of a firm's securities may notice that the combined value of debt and equity is less than the firm's assets. Given the firm has assets of $2,000,000 but the debt and equity sum up to $1,900,000 ($900,000 in debt and $1,000,000 in equity), there is an arbitrage opportunity. Assuming that there are no transaction costs or other market frictions, the arbitrager can earn a risk-free profit by simultaneously buying all the debt and equity and then liquidating the assets at their known value. This strategy leads to a profit equal to the difference between the asset value and the sum of the debt and equity values, which in this case is $100,000.
To understand this process, consider that bonds are debt securities a company can issue to borrow money, with promised interest payments and return of principal at maturity. If a company fails to make these payments, bondholders can demand repayment, potentially resulting in only partial recovery depending on the company's assets. In the given scenario, if the arbitrager acts quickly and the market prices have not adjusted, the arbitrager can buy the securities at the undervalued prices, which, when combined with the firm's assets, leads to an immediate profit without risk.