Tri Vi Dang Columbia University

Corporate Finance Spring 2018

Exercise Set 2

Due Thursday, 2/8

This problem set consists of four questions. You can obtain a maximum of 40 points.

Question 1 [16 points]

Consider an economy with three assets and two dates (t=0,1) and three states at t=1. Let

1 2 3 1.4 
 
X  2 1 4 p  1.8 
1 3 1 p 
 3

be the matrix of asset payoffs at t=1 and p the vector of asset prices at t=0.

Suppose p3=2.

(a) Is there an arbitrage? [3p]

(b) If yes, find an arbitrage portfolio. [3p]

Suppose p3=1.2.

(c) Does an arbitrage portfolio exist? [2p]

(d) Can you create a portfolio with payoff of (120, 190, 220) at t=1 and what is the t=0
price of such a portfolio? [4p]

(e) Determine the (implicit) risk free rate in this economy. [4p]

1
Question 2 [8 points]

Consider an economy with two dates (t=0,1) and at t=1 there are three states. The following
three stocks are traded:

x1=(10,0,30) x2=(0,20,40) x3=(20,20,0)

The t=0 prices of these stocks are given as follows

(p1, p2, p3)=(12, 14, 8).

(a) Is there an arbitrage? [2p]

Suppose an investment firm sells options.

(b) What is the t=0 price (premium) of a call option on stock 2 with exercise price E=10?
[3p]

(c) What is the t=0 price (premium) of a put option on stock 1 with exercise price E=12?
[3p]

Question 3 [6 points]

Consider the economy (above) again where the following set of stocks is traded:

x1=(10,0,30) x2=(0,20,40) x3=(20,20,0)

for the prices (p1, p2, p3)=(12, 14, 8).

Suppose a start-up company wants to go public. The firm has total costs of $80,000 at date
t=1 and sales of $100,000 in state 1, $120,000 in state 2, and $200,000 in state 3. The firm
wants to issue 1,000 IPO shares. (A share is endowed with a cash flow right of 0.1% of the
total profits of the firm.) The underwriter suggests an IPO price of $48 per share. Will this
IPO be successful, i.e. will there be a positive demand for the shares?

2
Question 4 [10 points]

(a) Financial engineering deals with the design of new assets. Draw the payoff (at t=1) of
the following bull butterfly spread:

Purchase 1 call with exercise price a

Sell 2 calls with exercise price (a+b)/2
Purchase 1 call with exercise price b

as a function of the underlying stock price S at t=1 where a=120 and b=140. [4p]

(b) An individual agent thinks that there is a high probability that the Dow Jones will have
a payoff (or points) between a=20,000 and b=23,000 at t=1.

Design a digital option (see Figure 1) as a sequence of calls on the Dow that converges
to a pure bet on getting $1 on the interval [20,000, 23,000], i.e. if the Dow lies
between S[20,000, 23,000] at t=1, then the portfolio of calls pays off exactly $1. The
payoff is 0 otherwise. [6p]

Figure 1 (Digital option)

payoff

a=20,000 b=23,000 S

Hint: You have to modify the sell strategies of a bull butterfly spread to obtain a payoff as
given in Figure 2 and then adjust n and  appropriately.

Figure 2
payoff of portfolio

1=n

a a+ b b S