University of Geneva - HEC

Advanced Finance
Fall 2014
Problem Set 3 Solution

1 Identifying Arbitrage [10 points]

 
2 0  
  1
Consider a market with payoff matrix A = 1 1, and price vector S =  . Decide whether there
 
  1001
0 2
are any arbitrage opportunities in this market, and if so, try to identify them by constructing a type I
or type II arbitrage portfolio x. If there is no arbitrage, give a vector of strictly positive state prices
consistent with the price vector of basis assets.

Solution

We will show that there is no arbitrage.

• The market is incomplete, since we have 3 states and 2 linearly independent assets.

• There is no obvious arbitrage, so we try to solve S = A0 ψ.

• Since r (AA0 ) = r (A) = 2, then AA0 , which is 3 × 3, isn’t invertible.

• So we solve it as system of linear equations, i.e., we solve

1 = A11 ψ1 + A21 ψ2 + A31 ψ3

1001 = A12 ψ1 + A22 ψ2 + A32 ψ3 .

• We find

ψ1 = ψ3 − 500

ψ2 = 1001 − 2ψ3

ψ3 is a free parameter.

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 • For ψ3 ∈ (500, 500.5), all state prices are positive, so the Arbitrage Theorem implies that there
doesn’t exist an arbitrage.

2 Consumption CAPM and State Prices [10 points]

Which of the following statements is correct?

a. The state price for a state is small when the true probability of the state occurring is high.

b. The stochastic discount factor is high when the personal discount factor β is low.

c. The state price for a state is high when the marginal rate of substitution for that state is high.

d. All of the above.

e. None of the above.

Solution

a. No, the opposite is true: The state price for state i is ψi = pi · mi , where mi is the value of the
stochastic discount factor for state i, and pi is the true probability of state i occurring.
0
b. No, the opposite is true, since the formula for the stochastic discount factor is mt+1 = β uu(c0 (ct+1
t)
)
.
0
c. Yes, the formula for the stochastic discount factor is mt+1 = β uu(c0 (ct+1
t)
)
.

Correct Answer: (c)

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3 Competitive Equilibrium [10 points]

Think of an Edgeworth box diagram. Which of the following statements is correct?

a. An equilibrium allocation, if it exists, is in the set of Pareto efficient allocations.

b. A Pareto efficient allocation is such that the indifference curves of the two agents through that point
are tangent.

c. If the initial allocation of assets is not Pareto efficient, then it is definitely possible to increase the
utility of one investor, without decreasing the utility of any other investor.

d. (a) and (b) are correct

e. All of the above.

Solution

a. Yes, this is the First Welfare Theorem

b. Yes.

c. An efficient (or Pareto Optimal) allocation is an allocation such that we can’t make one investor
better off without making any other investor worse off. So an inefficient (not Pareto Optimal)
allocation is such that we can make one investor better off without making any other worse off.

Correct Answer: (e)

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4 Pareto Set [10 points]

Consider an Edgeworth Box representation of an economy with two investors. Pareto Optimal allocations
in the Edgeworth Box are:

a. Points where the two investors’ indifference curves are tangent.

b. Points where the Marginal Rates of Substitution of the two individuals are equal.

c. Points representing allocations where one investor cannot be made better off without making the
other investor worse off.

d. All of the above are true.

e. None of the above.

Solution

All statements are correct:

a. Pareto Optimal points are points where the indifference curves of the two investors are tangent. If
the indifference curves of the two investors through a point aren’t tangent, then it is easy to see that
all the points lying between the two indifference curves are such that both investors can be made
better off; hence, such a point isn’t Pareto Optimal.

b. Since the indifference curves are tangent at Pareto Optimal points, that means that they have the
same slopes, and therefore the Marginal Rates of Substitution for the two investors are the same at
those points.

c. Pareto Optimal points are by definition points where one investor can’t be made better off without
making the other worse off.

Correct Answer: (d)

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5 Competitive Equilibrium [20 points]

Assume there are 2 investors (A, B) and 2 states (1, 2). Additionally, assume:

• Initial endowments are:

– Investor A has 12 units of the Arrow-Debreu security for state 1, and 2 units of the Arrow-
Debreu security for state 2.

– Investor B has 8 units and 18 units of the two Arrow-Debreu securities, respectively.

• Preferences are as follows:

– For investor A, we know that u xA A A

A

x2 , where xA A


1 , x2 = x1 1 and x2 are the quantities of

A-D security for state 1 and 2, respectively, that he owns.

– For investor B, we know that u xB B B

B

x2 , where xB B


1 , x2 = x1 1 and x2 are the quantities of

A-D security for state 1 and 2, respectively, that he owns.

Draw the Edgeworth box, showing the initial allocation. Is the initial endowment allocation Pareto
efficient?

Solution

The Edgeworth box looks as follows:

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where A and B indicate the origin for investors A and B, respectively, and the square indicates the initial
allocation. The initial endowment is not Pareto efficient. This can be shown by comparing the marginal
∂u
rate of substitution M RSx1 ,x2 = ∂x1
∂u between the two securities for investor A ( 16 ) and investor B ( 94 ).
∂x2
Because they are not equal, pareto improving trades exist.

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6 Asset Pricing in One-period Model [40 points]

Consider a model with 1 period and 4 states of the world. Consider the following assets:

1. A risk-free bond with return 1 on both borrowing and lending. Its price at t = 0 is 1.

2. A risky stock, whose return can be 0.5, 1, 1.5, or 2. Its price at t = 0 is 2.

3. A call option on the stock, with strike price 2. Its price at t = 0 is 0.5.

4. A put option on the stock, with strike price 2.

a. Consider first a market in which only the bond, stock, and call option are traded.

i. Is the market complete?

ii. Explain why there is or there is not arbitrage in this market. If there is arbitrage, how would
you exploit it?

b. Consider now that a bank introduces the put option in the market. At what price should it be sold?

c. Consider now that the bank has chosen to introduce the put option in the market, and sell it at a
price of 1. Explain why there is or there is not arbitrage in this market. If there is arbitrage, how
would you exploit it?

d. Consider now a market in which the only traded assets are the risk-free asset and the stock (with
payoffs and prices as above), together with another stock whose price is 2, and whose return is 0.25,
0.5, 1, and 3 when the return on the first stock is 0.5, 1, 1.5, and 2, respectively. You can safely
assume that there is no arbitrage in this market. Find the no-arbitrage price of the portfolio that is
the best approximate hedge for the digital call option on an “index” of the two stocks, with payoff

D = 1 if the sum of the stocks’ returns is above 2

D = 0 otherwise

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Solution

a. The payoff matrix and price vector are, respectively:

 
1 1 0  
  1
1 2 0
   
A= , S =  2 

  
1 3 1  
  0.5
1 4 2

i. We have 4 states and only 3 linearly independent assets, hence the market is incomplete.

ii. To check whether there is arbitrage or not, we need to check that there exist state prices ψ
such that S = A0 ψ, with all the elements of ψ positive. Since we have an incomplete market,
we solve the system

1 = 1 · ψ1 + 1 · ψ2 + 1 · ψ3 + 1 · ψ4

2 = 1 · ψ1 + 2 · ψ2 + 3 · ψ3 + 4 · ψ4

0.5 = 0 · ψ1 + 0 · ψ2 + 1 · ψ3 + 2 · ψ4

We find

ψ1 = 0.5

ψ2 = α

ψ3 = 0.5 − 2α

ψ4 = α

where α ∈ R.
Clearly, for α ∈ (0, 0.25), all elements of the state-price vector are positive. Thus, we conclude
that there is no arbitrage.

b. The payoffs of the risk-free asset, stock, call option, and put option are, respectively,
       
1 1 0 1
       
1 2 0 0
       
 , , , 
       
1 3 1 0
       
1 4 2 0

We can see that the payoff of the put option can be replicated by buying 2 bonds and 1 call, and
selling 1 stock. As a result, from no-arbitrage, its price should be equal to the cost of the replicating
portfolio, i.e., 2 · 1 + 1 · 0.5 − 1 · 2 = 0.5.

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c. There is arbitrage. We know from part (b) that the no-arbitrage price of the put is 0.5, so at 1, the
put is too expensive. You could buy the replicating portfolio (i.e., buy 2 bonds and 1 call, and sell
1 stock) and sell the put, for a total cost of 2 · 1 + 0.5 − 2 − 1 = −0.5 and a payoff of exactly 0 in
all states. This is a Type II arbitrage.

d. The payoff of the new stock is  

0.5
 
1
 
 
 
2
 
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There is no arbitrage, since

1 = ψ1 + ψ2 + ψ3 + ψ4

2 = ψ1 + 2ψ2 + 3ψ3 + 4ψ4

2 = 0.5ψ1 + 1ψ2 + 2ψ3 + 6ψ4

has solution  
2 − 6α
 
13α − 3
 
ψ= 
 2 − 8α 
 
 
α
3 1


which is a strictly positive state price vector for α ∈ 13 , 4 .
The sum of the stocks’ returns is above 2 in the third and fourth states, so the digital call option
has payoff (which is the payoff we are trying to replicate)
 
0
 
0
 
b= 
 
1
 
1

The payoff matrix of the basis assets is

 
1 1 0.5
 
1 2 1
 
A=



1 3 2
 
1 4 6

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and so we are trying to find x = (A0 A)−1 A0 b, which we know is the best approximate hedge for
payoff b. We have

−1 0
x = A0 A Ab
 
−0.6481
 
=  0.5296 
 
 
−0.0741

whose cost is  
−0.6481
h i 
S 0 x = 1 2 2  0.5296  = 0.2629
 
 
−0.0741

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