EXERCISES, I

Due Thursday, October 8th .

Exercise 1. Suppose that there are two states of nature, S = {1, 2}, and two
securities, J = {1, 2}, with payoffs z 1 = (1, 3) and z 2 = (−1, 2). Verify whether
markets are complete or incomplete.
Exercise 2. Suppose that there are two states of nature, S = {1, 2}, and two securi-
ties, J = {1, 2}, with payoffs z 1 = (1, 3) and z 2 = (−2, −6). Verify whether markets
are complete or incomplete. Explain the difference with the previous exercise.
Exercise 3. Suppose that there are a finite set of states of nature, S, and two
securities, J = {1, 2}. Security 1 pays off one unit of account in all states of
nature; security 2 pays off 2 units of account in state of nature 1, −1 units of
account is states of nature 2 and no units of account in all other states of nature.
Describe the set of security prices ruling out arbitrage opportunities.
Exercise 4. Suppose that there are two states of nature, S = {1, 2}, and three
securities, J = {1, 2, 3}, with payoffs z 1 = (3, 2), z 2 = (1, 0) and z 3 = (2, 1).
Security prices are q1 = 10, q2 = 12 and q3 = 10. Show that there exists an
arbitrage opportunity.
Exercise 5. There are a finite set of states of nature, S, and a single risk-less
security, with unitary payoff and unitary market price (hence, trivially, security
prices exclude arbitrage opportunities). For a contingent claim (xs )s∈S in RS ,
compute the upper value,
πu (x) = inf {ϕ (x) : z ≥ x} ,
z∈Z
and the lower value,
πl (x) = sup {ϕ (x) : x ≥ z} .
z∈Z
(If necessary, also assume that S = {1, 2}.)
Exercise 6. There are two states of nature, S = {1, 2}, occurring with the same
probability. A portfolio of securities pays off a large amount of money in state 1
(say, 101000 ), but involves a small loss in state of nature 2 (say, −10−1000 ). Such
a portfolio has zero market value at current security prices. Does this imply an
arbitrage opportunity? Discuss.
Exercise 7. Suppose that there are two states of nature, S = {1, 2}, and two
securities, J = {1, 2}, with payoffs z 1 = (1, 3) and z 2 = (−1, 2). Security prices are
q1 = 4 and q2 = 1. Show that security prices exclude arbitrage and recover state
prices.
Exercise 8. Suppose that there are two states of nature, S = {1, 2}, and two
securities, J = {1, 2}, with payoffs z 1 = (1, 3) and z 2 = (−1, 2). Security prices are
q1 = 4 and q2 = 1. Describe (graphically and analytically) the set
V = {z ∈ Z : ϕ (z) = 0}
1
or, equivalently,
V = {z ∈ Z : z = R (h) for some h ∈ H satisfying q (h) = 0} .
Exercise 9. Suppose that there are two states of nature, K = {1, 2}, and consider
a market that is implemented by spot trading of an asset D  R2 with spot price
S > 0, a unit discount bond with corresponding discount factor ρ > 0, and a call
option on the asset D with strike L, which is the asset (D − L1)+ . The option’s spot
price, known as its premium, is Sc . The possible values of D are D1 = (1 + u)S in
state one and D2 = (1 + d)S in state two, where u > d > −1.
• Derive necessary and sufficient conditions on the parameters for the market
implemented by spot trading on the stock and the bond to be arbitrage-free.
Assume these conditions are satisfied for the remainder of this question.
• Show that the market implemented by spot trading in the stock and the bond
is complete and compute the corresponding state-price vectors.
• Compute the arbitrage price Sc of the call using a state-price vector.