PROBLEM SET

5.1 Security A pays $30 if state 1 occurs and $10 if state 2 occurs. Security B pays $20 if state 1 occurs
and $40 if state 2 occurs. The price of security A is $5 and the price of security B is $10.

a) Set up the payoff table for securities A and B.

The payoff table for securities A and B is as shown below.

Payoff
State 1 State 2 Security prices
Security A 30 10 5
Security B 20 40 10

b) Determine the prices of the two pure securities.

The answer provided below has been developed in a clear step by step
manner.Step: 1

a)
The prices of the pure securities are given by the equations below:
P1QA1 + P2QA2= PA
P1QB1 + P2QB2 = PB
Substituting the correct numbers,
12 P1 + 20 P2 = 22
24P1 + 10P2 = 20
Solving these two equations by multiplying equ 2 by 2
12P1 + 20 P2 = 22
48 P1 + 20 P2= 40
36P1= 18
P1= 0.5
P2= 0.8

Explanation:Please refer to solution in this step.Step: 2

b) Initial price of third security

By substituting the values calculated above =
6 * (0.5) + 10 * (0.8)
= 3 + 8 = $11
Explanation:Please refer to solution in this step.

Answer:

a) prices are 0.5 and 0.8 respectively

b) From the prices we calculate initial price is $11