Jeremey Ponrajah

#500454552
EF8904 Assignment #4

Problem

(i) Suppose you observe the following assets with the corresponding statedependent payoffs:

3 1 7
7 2 16
8 9 25
where each row is a security and each column is a state. For example, the
middle security pays 16 in state 3. Is this market complete?


3 1 7 


det A = 7 2 16 = 3(50 144) (175 128) + 7(63 16) = 0
8 9 25
This market is not complete because the determinant is zero meaning the
matrix is not invertible. Furthermore, it implies that the assets are not
linearly independent.
(ii) Explain why the following market

1 3
5 6
12 14

structure is not complete:

12 15
7 8
16 20

The market is not complete because the matrix is not invertible. Therefore,
Arrow-Debreu securties cannot be created for each state.
C1 ([ 1 3 12 15 ]; 1) = [ 0 2 11 14 ]


 1 3 12 15


5 6 7 8

 = 14
det A = 

12 14 16 20
 0 2 11 14
The determinant is non-zero therefore the matrix is invertible impling markets are complete.
1

(iii) Construct an Arrow-Debreu security to complete the market by introducing calls or puts on the assets. Can you complete the market with
only calls? Can you complete the market with only puts?

C2 ([ 5 6 7 8 ]; 7) = [ 0 0 0 1 ]


 1 3 12 15


5 6 7 8
 = 14

det B = 

12 14 16 20
0 0 0 1
P3 ([ 5 6 7 8 ]; 6) = [ 1 0 0 0 ]


 1 3 12 15


5 6 7 8

 = 90
det B = 

12
14
16
20


1 0 0 0
Yes, markets can be completed with either puts or calls.

Problem

Consider a binomial tree for a security with u = 1.11 and d = u1 = 0.90. The
current price of the security is p(s0 ) = 50 and the risk free rate is Rf = 1.05.
The binomial process is illustrated in Figure 1.
(i) Derive the prices for a pair of Arrow securities (that is, a one-periodahead contingent claim that pays one unit if state u is realized next period
and zero otherwise, and the analogous contingent security for state d).
1 Rf d
1 1.05 0.90
)(
)=
(
) = 0.68
Rf u d
1.05 1.11 0.90
1 u Rf
1 1.11 1.05
= d) = ( )(
)=
(
) = 0.27
Rf u d
1.05 1.11 0.90

q(st , st+1 = u) = (
q(st , st+1

(ii) Write down an expression for the period t price of a European call
option that expires at time T = t + 2 with exercise price K = 45, denoted
CT (st , K) = Ct+2 (st , 45).
2  
1 X 2
Ct+2 (st , 45) =
( RN )k (1 RN )2k max[uk d2k p(st ) 45, 0]
1.052
k
k=0

(iii) Compute the price of the call option, Ct+1 (st , 45), using either the expression from part (ii) or by working backwards from time t + 2.
Ct+2 (st , 45) =

1
[(1 RN )2 max[d2 p(st ) 45, 0] + 2( RN )(1 RN )max[u d p(st ) 45, 0]
1.052
+( RN )2 max[u2 p(st ) 45, 0]]
(((

((
1
RN(2((((
Ct+2 (st , 45) =
[(1

)
max[40.5
45, 0] + 2( RN )(1 RN )(4.95)
(
(
2 ((
1.05
((
(
+( RN )2 (16.605)]

1
[2( RN )(1 RN )(4.95) + ( RN )2 (16.605)]
1.052
1
[2(0.714)(0.28)(4.95) + (0.714)2 (16.605)]Ct+1 (st , 45) = 9.47
=
1.052

Ct+1 (st , 45) =

Problem

[APT and CE] Consider a two-period exchange economy with two agents
that maximize expected utility. They have identical Bernoulli utility functions:
log ci0 + log ci1 (s), i = 1, 2
where ci0 is agent is consumption level at date 0, and ci1 (s) is agent is
consumption level at date 1 if state s occurs. There are two equally likely
states at date 1. Consider the following endowment structure:

In addition to non-contingent claim (i.e., a discount bond), there exists a

second security that pays z units of the consumption good in state s1 , and
zeros otherwise.
(i) Are markets complete?


1 1

 = z
det A = 
z 0
As long as -z is greater than zero markets are complete.
(ii) Let q denote the price of the non-contingent claim, and p denote the
price of the contingent claim. Let bi and ai denote agent i?s demand for
non-contingent and contingent claims. Write down the agents? optimization
problems.
1
max log(3 qb1 pa1 ) + [log(1 b1 za1 ) + log(4 b1 )]
1
1
2
a ,b
s.t. a1 + a2 = 0, b1 + b2 = 0
1
max log(3 qb2 pa2 ) + [log(5 b2 za2 ) + log(2 b2 )]
2
2
2
a ,b
s.t. a1 + a2 = 0, b1 + b2 = 0
(iii) Solve for the competitive equilibrium.
F.O.C.
p
1
z
+ (
)
3 qb1 pa1 2 1 b1 za1
q
1
1
1
b1 :
+ [
+
]
3 qb1 pa1 2 1 b1 za1 4 b1

a1 :

z
p
1
+ (
)
3 qb2 pa2 2 5 b2 za2
q
1
1
1
b2 :
+ [(
)+
]
3 qb2 pa2 2 5 b2 za2
2 b2

a2 :

Giving markets are complete we can solve for consumption through ArrowDebreu securities.
4

Agent 1:
1
1
max log c10 + log c11 (s1 ) + log c11 (s2 )
2
2
c10 ,c11 ,c12
s.t. c10 + q1 (s1 )c11 (s1 ) + q1 (s2 )c11 (s2 ) 3 + q1 (s1 ) + 4q1 (s2 )
c10 , c11 (s1 ), c11 (s2 ) 0
Agent 2:
1
1
max log c20 + log c21 (s1 ) + log c21 (s2 )
2
2

c20 ,c21 ,c22

s.t. c20 + q1 (s1 )c21 (s1 ) + q1 (s2 )c21 (s2 ) 3 + 5q1 (s1 ) + 2q1 (s2 )
c20 , c21 (s1 ), c21 (s2 ) 0

F.O.C.
1
q1 (s1 )
2
=
, i = 1, 2
ci0
ci1 (s1 )
1
q1 (s2 )
2
, i = 1, 2
=
ci0
ci1 (s2 )

where:

ci0 = y0 + q1 (y1i (s1 ) ci1 (s1 )) + q2 (y1i (s2 ) ci1 (s2 )), i = 1, 2
Taking the ratio of the first-order conditions for agents 1 and 2 yields:
c20
c2 (s1 )
c2 (s2 )
= 11
= 11
1
c0
c1 (s1 )
c1 (s2 )
which implies:
c20 1
c (s1 )
c10 1
c2
c21 (s2 ) = 10 c11 (s2 )
c0
c21 (s1 ) =

Market clearing conditions:

c10 + c10 = 6
c11 (s1 ) + c21 (s1 ) = 6
c11 (s2 ) + c21 (s2 ) = 6
By nothing we can get:
c10
6
+ c20
c1
c11 (s2 ) = 1 0 2 6
c0 + c0
c2
c21 (s1 ) = 1 0 2 6
c0 + c0
c2
c21 (s2 ) = 1 0 2 6
c0 + c0

c11 (s1 ) =

c10

= c11 (s1 ) = c10

= c11 (s2 ) = c10
= c21 (s1 ) = c20
= c21 (s2 ) = c20

We obtain the equilibrium prices:

1
1
q1 (s1 ) = , q1 (s2 ) =
2
2
Budget constraint Agent 1:
1
1
1
c10 + c11 (s1 ) + c11 (s2 ) 3 + + 2 = c10 = c11 (s1 ) = c11 (s2 ) = 2.75
2
2
2
Budget constraint Agent 2:
1
1
c20 + c21 (s1 ) + c21 (s2 ) 3 + 2.5 + 1 = c10 = c21 (s1 ) = c21 (s2 ) = 3.25
2
2
Substituting into the original F.O.Cs we get:
p
1 z
+ (
)
2.75 2 2.75
q
1 1
1
+ [

]
2.75 2 2.75 2.75
6

By nothing:
p=

z
,q = 1
2

c11 (s2 ) = 4 b1 = b1 = 1.25

c21 (s2 ) = 2 b2 = b2 = 1.25
3
z
3
2
2
2
2
c1 (s1 ) = 5 b za = a =
z

c11 (s1 ) = 1 b1 za1 = a1 =

(iv) Suppose one of the agents is considering introducing a set of ArrowDebreu securities to be traded as well. What should be the relationship
between the prices of these A-D securities and prices q and p for the existing
securities?
The relationship between the price of the Arrow-Debreu and the two other
assets should be the following:
p = [zq1 (st )]