Assignment 1

Question 1 i) The payment matrix according to the specied payouts in the question is as follows:

Q:
B GW FW BW 20 20 20 S 60 30 5 C 45 5 0

The security prices are:

Ps:

0.0015 -0.059 0.0294

-0.0132 0.0529 -0.0647

0.0618

Patomic = [ 0.15 0.25 0.5]

ECON3107: ECONOMICS OF FINANCE!

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Ps * inv(Q)=

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-0.0471 0.0353

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Q-1 =

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To calculate the arbitrage-free price of the atomic securities, multiply the vector of security prices by the inverse of the payment matrix.

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18

19

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BOND

STOCK

SECURITY C

ii) The arbitrage-free price of the apple tree is calculated by multiplying p, the vector of elemental security prices and q,the vector of payments

P x q= P:
0.15 0.25 0.5

q:
GW FW BW 80 50 25

Therefore through matrix multiplication, the arbitrage-free price of the apple tree is 37 present apples. iii)

GA FA BA

30 30 50

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C:

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Investor!s payout in which he receives 30 apples if the weather is good or fair and 50 apples if the weather is bad.

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iv)

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Due to this calculation, an apple a year from now has a present value of 0.9 apples regardless of the type of transaction.

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0.15 + 0.25 + 0.5 = 0.9

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The discount factor is calculated by adding the atomic security prices. It represents the present value of a one unit payment to be made with certainty at the specied future date.

The payment matrix of securities {states x securities}

Q:
B GW FW BW 20 20 20 S 60 30 5 C 45 5 0

To compute the portfolio to provide the payouts as specied in matrix C, multiply the inverse of Q with the payouts C

N = Q-1 x C N:
BONDS STOCK SECURITY C 2.7353 -0.9412 0.7059 The replicating portfolio to provide the payments in "C! is shown the the left. The negative stock value indicates the short sell -0.9412 stocks to buy 2.7353 worth of bonds and 0.7059 worth of security C to provide 30 apples in good or fair weather and 50 apples in bad weather.

BOND 18

STOCK 19

SECURITY C 8

ps x N

v)

The call option!s value derives from the value of the stock at time 1. The option will only be exercised if the payout is higher than the price of the option which is 25. Therefore from the stock payouts shown on the following page, the option will only be exercised in good weather and fair weather as there is a positive net inow of apples. Thus the Net payoff vector is the payout from the stock minus the price of the option except for in bad weather where the option is not exercised.

ECON3107: ECONOMICS OF FINANCE!

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By multiplying this portfolio "N with the securities price vector ps gives the price of the portfolio which is 37 present apples.

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Ps:

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Stock!s payoff 60 30 5

Net Payoff 35 5 0

Thus to compute the price of the call option, multiply the vector of atomic security prices "Patomic! against the vector of net payoffs. It shows that the European call option is worth 6.5 present apples.

Pxc=

[0.15 0.25 0.5]

35 5 0

=6.5PA

Question 2 i)

B0 G B GG GB BG BB 1.05 1.05 0 0 0 0

S0 1.3 0.9 0 0 0 0

Bg -1 0

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Sg -1 0

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Bb 0 -1 0 0 1.05 1.05 Sb 0 -1 0 0 1.3 0.9 1.05

Q {states x securities}:

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0 0 Sb 0

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Bb 0

1.05

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B0 1

S0 1

Bg 0

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Ps:

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Sg 0

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0 0

1.3 0.9

ii)#

To compute the atomic security prices the following formula was used.

Patomic= ps x Q-1
Through the application of the above formula, the vector of atomic security prices are as follows: Patomic = G 0.3571 iii) The european call option will only be exercised if the price of the stock in the second period is above the strike price of 1.05. A prot is attained when the option is exercised at the option price which is below market price and subsequently selling the stock received at market price. Hence in this model, this will occur in every state except in state "bb!. iv) The value of the stock at t=2 Gg Gb Bg Bb 1.69 1.17 1.17 0.81 B 0.5952 Gg 0.1276 Gb 0.2126 Bg 0.2126 Bb 0.3543

B Gg Gb Bg

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0 0

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C:

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If it costs 1.05 to exercise the call option and it will only be exercised at stock values above the option price, the net payoffs will thus be shown in the time-state vector below denoted "C!

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0 0 0.64 0.12 0.12
! 5

Max(0,1.69-1.05) Max(0,1.17-1.05) Max(0,1.17-1.05)

ECON3107: ECONOMICS OF FINANCE!

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Bb Patomic = G 0.3571 B

Max(0,0.81-1.05)

Gg 0.1276

Gb 0.2126

Bg 0.2126

Bb 0.3543

0.5952

To arrive at the arbitrage-free price of the call option, multiply the vector of atomic security prices with the matrix "C! shown above. Price = patomic x c = {1x states} x {states x 1} = (0.64 x 0.1276) + (0.12 x 0.2126) + (0.12 x 0.2126) = 0.1327 Therefore, arbitrage-free price of the European call option will be $ 0.1327. v) Put options are options to sell the underlying stock at a predetermined price and date. The option will only be exercised if the value of the underlying stock at the expiration date is lower than the exercise price. By simultaneously buying stock at market value and exercising the option to sell the security at a higher price, an investor will be able to attain a prot. vi)

Gg Gb Bg Bb

1.69 1.17 1.17 0.81

The payoff matrix "C! below highlights the possible cash ows.

C:
G B 0 0 0 0
6

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Depending on the state of the world, the put option will only be exercised if the value of the stock is lower than the exercise price of 1.05. Through observation, only the state of "bb! would result in the option being exercised. The net payoff for this particular state would be "1.05-0.81! which is the sum received from exercising the option against the price of the stock being sold at market value.

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The value of the stock at the second period:

Gg Gb Bg Bb Patomic = G 0.3571

Max(1.05-1.69,0) Max(1.05-1.17,0) Max(1.05-1.17,0) Max(1.05-0.81,0)

0 0 0 0.24

B 0.5952

Gg 0.1276

Gb 0.2126

Bg 0.2126

Bb 0.3543

The cost of providing these cash ows equals "p x c! being the vector of atomic security prices multiplied by the vector of cash ows. Price = patomic x c = {1x states} x {states x 1} = 0.24 x 0.3543 = 0.085 According to the calculations above, the cost of providing the European put option and its associated payoffs will be $0.085.

ECON3107: ECONOMICS OF FINANCE!

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