Tri Vi Dang

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

This equation system has a unique solution.

q1 0.9

q 2 0.4 .
q 0.1

Since q3=0.10, there is arbitrage.

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

=(0.625, 0.125, 0.375)

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

At t=0, one gets $0.1

Ar t=1, one never has a negative payment, but gets $1 in state 3.

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

q=(0.4, 0.2, 0.2) is the unique solution.

Since q>>0, there is no arbitrage

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)

Price of this portfolio with payoff (0,10,20) is

p=15p15p25p3=6
Remark 3
Alternative approach
Buy 0 unit of contingent claim 1, 10 units contingent claim 2, and 20 units of contingent claim
3:
ph= 10q2+20q3=6

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

q=(0.4, 0.1, 0.2)

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)

p C 0.8 0.4 0.8 0.1 0 0.2 0.4

Put option with E=2 on x2=(1,0,3)

Payoff of this call option is: (1,2,0)
Price of an asset with payoff (1,2,0)

p C 1 0.4 2 0.1 0 0.2 0.6

Solution 3
Payoff of firm at t=1:
state 1

state 2

state 3

20000
-10000
______

40000
- 10000
______

100000
-10000
______

10000

30000

90000

State price vector in this economy: q=(0.4, 0.1, 0.2)

Total value of firm

V 10,000 0.4 30,000 0.1 90,000 0.2 25,000

Price per share

V
25
n

Payoff per share=(10,30,90)

p 10 0.4 30 0.1 90 0.2 25

The price is too high. There is no demand.
5

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)

Payoff of call (E=(a+b)/2) = S

(short 2 units =-2S, slope =-2)

Net payoff = -S
For S>b
Payoff of call (E=a) = S

(slope 1)

Payoff of call (E=(a+b)/2) =S

(short 2 units =-2S or slope =-2)

Payoff of call (E=b) =S

(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

Payoff of this portfolio

=C(x, a) C(x, a+) C(x, b) +C(x, 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+

As 0, the trapezoid converges to a quader.

Payoff of 1 implies n=1. (This means n .)