Assignment 1.

Introduction to Derivatives:
Complete markets and the Inverse problem.
Prof. Raúl Espejel
Universidad Anáhuac Querétaro

Student: Valeria Ruiz Mollinedo

ID: 00360687

1. What is a derivative?

A derivative is a security with a price that is dependent upon or derived from one or more
underlying assets. The derivative itself is a contract between two or more parties based
upon the asset or assets.

2. What is the difference between a discrete and a continuous variable?

A discrete variable is a variable whose value is obtained by counting. A continuous variable

is a variable whose value is obtained by measuring. A random variable is a variable whose
value is a numerical outcome of a random phenomenon. A discrete random variable X has
a countable number of possible values.

3. Finance is a discipline with a strong focus on pricing assets. There are various models,
theories, and techniques to price assets (general equilibrium models such as the CAPM,
arbitrage models such as the APT, risk-neutral pricing, martingale pricing, option pricing,
DCF etc..). However, there are three key sets of assumptions that all models or theories
need to address to provide a self-consistent, coherent framework. Please mention and
briefly describe these three sets of assumptions.

Neoclassical economists believe the propensity for consumer needs drives the economy
and the business production that results to fill those needs. Any imbalances in an economy
are believed to be corrected through competition, which restores equilibrium in the
markets allocating resources properly.
Neo-classical economics works with three basic assumptions:
- People have rational preferences among outcomes that can be identified and associated
with a value.
- Individuals maximize utility (as consumers) and firms maximize profit (as producers).
- People act independently on the basis of full and relevant information.

These assumptions are used to help predict the decisions of players in an economy and
how different players use scarce resources.

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4. What is the expected value and variance of a random variable, and why are they
important in asset (and derivatives) pricing?

The expected value is a parameter, meaning a fixed quantity. The population variance of a
random variable is the expected value of the squared deviations from the population
mean, that is, the expected value of (x−μ)2. The expectation describes the average value,
and the variance describes the spread (amount of variability) around the expectation. This
is important because it helps us to know and calculate the real price of a derivate.

5. What does Diminishing Marginal Utility mean? Why is this a common assumption in
financial models?

The phenomenon that each additional unit of gain leads to an ever-smaller increase in
subjective value. For example, three bites of candy are better than two bites, but the
twentieth bite does not add much to the experience beyond the nineteenth (and could
even make it worse). It’s a common assumption since this concept helps to explain savings
and investing versus current consumption and spending.

6. Why do most consumers like to buy insurance products? What is the certainty
equivalent?

Consumers usually don't get any financial benefit in return for the premium they pay.
However, in addition to financial benefits, insurance products offer moral benefits such as
peace of mind and a feeling of safety. The certainty equivalent is a guaranteed return that
someone would accept now, rather than taking a chance on a higher, but uncertain, return
in the future. Put another way, the certainty equivalent is the guaranteed amount of cash
that a person would consider as having the same amount of desirability as a risky asset.

7. What is risk-neutral probabilities?

Risk-neutral probabilities are probabilities of possible future outcomes that have been
adjusted for risk. Risk-neutral probabilities can be used to calculate expected asset values.
Risk-neutral probabilities are used for figuring fair prices for an asset or financial holding.

8. What is the “Inverse Problem” in financial economics?

The inverse problem is to infer the value of parameters of interest based on the direct
measurement of observables. In statistics an inverse problem would be an inference or
estimation problem where the data are finite in number and contain errors, as they do in
classical estimation or inference problems, and the unknown typically is infinite-
dimensional, as it is in nonparametric regression.

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9. What are the first, second and third Fundamental Theorems of Financial Economics?

- Risk-neutral probabilities exist if and only if there are no riskless arbitrage opportunities.
- The risk-neutral probabilities are unique if and only if the market is complete.
- Under certain conditions, the ability to revise the portfolio of available securities over
time can make up for the missing securities and effectively complete the market.

10. A riskless arbitrage opportunity exists if and only if:

Arbitrage can be used whenever any stock, commodity, or currency may be purchased in
one market at a given price and simultaneously sold in another market at a higher price.
The situation creates an opportunity for a risk-free profit for the trader since arbitrage
provides a mechanism to ensure that prices do not deviate substantially from fair value for
long periods of time.

11. What is a complete market?

A financial marketplace is said to be complete when a market exists with an equilibrium

price for every asset in every possible state of the world.

12. Why is the third theorem of financial economics so important for practitioners?

Because through its application it is possible to replicate and assure that the markets are
complete.

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13. Please solve the following problem. Suppose you are trying to obtain the price of a Put
Option on the asset with strike = $75.00. The option expires in one year. There are three
“states of nature” that define the potential outcome for all assets (the states are labeled
S1, S2, and S2), and there are three existing assets with the following sets of payoffs and
prices:
Payoff Matrix
Assets
Stock Cash Call Option
S1 154.995155 100.000000 124.995155
S2 50.000000 100.000000 20.000000
State

S2 16.129536 100.000000 -

Prices
Stock Cash Derivative
50.0000000 92.9017274 26.8667302
Notice that the call option has a strike price of $30, since for every state of nature, the
payoff of the call option at maturity is: Max( Stock price – Strike price, 0)
Please compute:
1. The matrix of weights of the portfolios composed by the stock , the risk-free bond
and the call option that replicate the payoff of the three basis securities, and verify
that those portfolios indeed replicate the desired payoffs (e.g. (1,0,0) for the basis
security one etc.).
2. Compute the price of the basis securities using the portfolios obtained in the
previous step (the matrix), and the asset prices.
3. Calculate the risk-neutral probabilities using the payoff matrix of the assets and
asset prices (please remember to use the transpose of both the matrix of assets
and the vector of asset prices).
4. Verify that the price of the basis securities is indeed the present value of the risk-
neutral probabilities.
5. Compute the price of the put option using the price of the basis securities.
Remember that the payoff of the Put Option is = Max (Strike Price – Stock Price, 0)
for every state of nature