Assignment:
Question 1
Two securities J and K are trading in the market. Their end-of-period payoffs for state 1 and state 2, and their current traded market prices, are shown in the table below
Security Payoff (S1, S2) Traded Price
J (2,3) $0.08
K (3,1) $0.05
What is the no-arbitrage value of security L with end-of-period payoffs (1,4)?
Question 2
Three securities, T, U and V are trading in the market. Their end-of-period payoffs for state 1 and state 2, and their current traded market prices, are shown in the table below:
Security Payoff (S1, S2) Traded Price
T (1,0) $0.60
U (0,1) $0.70
V (4,3) $4.30
Construct a trade consisting of T, U and V to extract an arbitrage profit. Make sure that you clearly specify which securities are bought or sold as well as the size of the arbitrage profit.
Question 3
The risk-free interest rate for the period is 10%. An underlier currently trades at $100, and it is expected to trade at either $90 or $120 at the end of the period.
(i) What is the no-arbitrage value of a forward contract on the underlier if the forward asset price in the contract is $110?
(ii) Explain why the value in (i) is that value.