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Corporate Finance
Columbia University
Fall 2013
Answer Key 2
Solution 1(a)
Application of the Fundamental Theorem: Xq=p
1 2 3 q 1
2 1 4 q
2
1 3 1 q 3
q1
2q 2 3q 3 1.4
2q1 q 2
q1
p1
p2
p
3
4q 3 1.8
3q 2 q 3
q1 0.9
q 2 0.4 .
q 0.1
Interpretation
q3=0.1 means, that the state contingent claim e3=(0,0,1) has a negative price.
One gets $0.1 for buying this asset.
Remark 1
Even if such an asset is not traded explicitly, one can replicate its payoff with other assets.
Solution 1(b)
A profitable trading strategy is to create a portfolio that has a payoff of (0,0,1).
!
X e 3 (0, 0, 1)
1 2 3
(1, 2, 3) 2 1 4 =(0,0,1)
1 3 1
1 2 2 3 0
21 2 3 3 0
31 4 2 3 1
Buy 0.625 unit of asset 1, sell 0.125 unit of asset 2, and sell 0,375 unit of asset 3.
Price of this portfolio
ph=p=0.625p10.125p20.375p3= 0.1
=q1
Sure Arbitrage
Remark 2
If one buys 625 units of asset 1, sell (short) 125 units of asset 2 and 375 units of asset 3, one
receives $100 in t=0.
By scaling up this strategy, the profit at t=0 is arbitrary large.
Every investor would like to do this.
Therefore, No Arbitrage might be an intuitive and reasonable criteria for thinking about asset
prices.
Solution 1(c)
1 2 3
X 2 1 4
1 3 1
1.4
p 1.8
1.2
Solution 1(d)
!
X x (0,10, 20)
1 2 3
(1, 2, 3) 2 1 4 =(0,10,20)
1 3 1
1 2 2 3 0
2 1 2 3 3 10
3 1 4 2 3 20
=(15, 5, 5)
Solution 1(e)
Riskfree rate
q=(0.4, 0.2, 0.2)
Riskless asset with sure payoff of 1 at t=1: (1,1,1)
Buy three contingent claims
Price at t=0
q1 q 2 q 3 0.8
yield sure payoff of 1 at t=1
Return (risk free rate)
q1 q 2 q 3
1
1 r
r=0.25
Solution 2(a)
Solve the NA equation
2 2 0 q 1
1 0 3 q
2
0 2 4 q 3
2q1
2q 2
1
3q 3 1
q1
2q 2
p1
p2
p
3
4q 3 1
There is no arbitrage.
Solution 2(b)
Call option with E=1.2 on x1=(2,2,0)
Payoff of this call option is: (0.8,0.8,0)
Price of an asset with payoff (0.8,0.8,0)
Solution 3
Payoff of firm at t=1:
state 1
state 2
state 3
20000
-10000
______
40000
- 10000
______
100000
-10000
______
10000
30000
90000
V
25
n
Solution 4
Portfolio of
Purchase 1 call with exercise price a
Sell 2 calls with exercise price (a+b)/2
Purchase 1 call with exercise price b
payoff
(a+b)/2
For S<a,
All calls are out of money (worthless)
For a<S<(a+b)/2
Payoff of call (E=a) = S (slope 1)
Other calls worthless
For (a+b)/2<S<b
Payoff of call (E=a) = S
(slope 1)
Net payoff = -S
For S>b
Payoff of call (E=a) = S
(slope 1)
(slope =1)
Net payoff = 0
6
Solution 5
payoff
Strategy
Long n calls with E=a
Short n calls with E=a+
Short n calls with E=b
Long n calls with E=b
0
n (S a )
n
n (b S)
,S a
,a S a
,a S b
,b S b
,S b
payoff of portfolio
a+