Assignment 1

ECON3107/ECON5106 – Economics of Finance

Please read carefully.

The Deadline:
A hard copy of this assignment has to be submitted to marked Economics Assignment
Box 2, located on the ground floor of the Business School building, in the West wing. You
do not have to use plastic sheets or binders. Simply staple the pages together. Your name
and ID must be on the cover page. The deadline for submission is Friday, 23 March
2018, 4.00pm. This assignment counts for 5% of the final mark. The assignment
must be typed.

Electronic Copy:
An electronic copy has to be submitted through Moodle by Friday, 23 March 2018,
4.00pm. The electronic copy may be submitted a few days before. Make sure the copy
submitted electronically is the same as the hard copy; penalties may apply otherwise.

Late Submission Policy:

There is a late submission penalty if you fail to submit your Assignment by the given
deadline. The penalty works as follows. All assignments submitted before the 4.00pm
deadline to the Assignment Box will be picked up. Assignments submitted in the next
48 hours after the deadline receive a 30% penalty. Assignments submitted even later will
not be marked. Special consideration does not apply to late submission of assignments.
The hard and electronic copy must both be submitted before the deadline.

Plagarism vs Discussing with peers

All assignments will be checked for plagiarism. See notes on Plagiarism in the Course
Outline. While discussing the assignments with peers is encouraged, do not lend your
assignment to another student. When an assignment is copied, it is difficult for the
instructor to determine who the copier is and you may be penalised heavily. It is in your
interest to do the assignment yourself since it is the best way to learn and prepare for the
exam.

Marking Criteria: Do not just write a number down. Explain how you arrive at your
answer and provide intuition. This does not imply you should write unnecessarily. I expect
your calculations to go together with an explanation that reveals your understanding. The
last page contains details about the marking criteria.

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Questions
1) Consider a world in which there are only two periods: period 0 and period 1 and three
possible states of the world in period 1 (a good weather state, a fair weather state, and a
bad weather state). Also, apples are the only product produced in this world, and they
cannot be stored from one period to the next. The following abbreviations will be used:
PA = apple in the present period (i.e., present apple), GA = good weather apple in the
next period, FA = fair weather apple in the next period, BA = bad weather apple in the
next period.
Suppose that an apple tree firm offers for sale a bond and stock. The apple tree
produces 80 GA, 50 FA, and 25 BA. The bond pays 20 GA, 20 FA and 20 BA. The stock
pays 60 GA, 30 FA and 5 BA. The price of the bond is 18 PA, and the price of the stock
is 22 PA. In addition, security C, D, and E are traded for 31 PA, 11 PA, and 10 PA
respectively. Security C pays 70 GA, 40 FA, and 15 BA. Security D pays 30 GA, 15 FA,
and 2.5 BA. Security E pays 40 GA, 10 FA, and 0 BA.

1.1) Find the arbitrage-free price of the atomic securities.

1.2) Calculate the arbitrage-free price of an apple tree. Verify it equals the price implied
by the firm’s securities.

1.3) Calculate the discount factor and explain its economic interpretation. How is it
related to the risk-free interest rate?

1.4) An investor wants a security that will pay 30 GA, 30 FA, and 50 BA in period 1.
Construct such a security and determine its arbitrage-free price.

1.5) Compute the arbitrage-free price of a security that will pay 45 GA, 15 FA, and 0 BA
in period 1. This is not necessary to solve the problem, but note that this security is
equivalent to a European call option to buy the stock at a strike price of 15 in period 1.

1.6) Design a profitable arbitrage strategy if security C costs 32 PA instead.

2) Consider another world similar to the one considered in Question 1 except there is a
new set of atomic prices involving dealers.

2.1) Dealer I is willing to trade 0.15PA for 1GA (or vice versa), and dealer II is willing
to trade 1GA for 0.6FA (or vice versa) and dealer III is willing to trade 1FA for 0.5BA.
a) What is the arbitrage-free price of a BA in terms of PA? b) What is the arbitrage-free
discount factor?

2.2) In addition, dealer IV is willing to trade 1 PA for 4 BA (or vice versa). Are there
arbitrage opportunities? If so, design a profitable arbitrage strategy.

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2.3) Suppose now there are transaction costs. The four dealers have the following bid-ask
spreads:

Dealer I: sell 1PA for 7GA

buy 1PA for 5GA

Dealer II: sell 1GA for 0.7FA

buy 1GA for 0.5FA

Dealer III: sell 1FA for 0.6BA

buy 1FA for 0.4BA.

Dealer IV: sell 1PA for 5BA

buy 1PA for 3BA.

Are there arbitrage opportunities now? Explain.

2.4) Optional (Not graded): You have been hired by a financial investment company
to write a MATLAB script that detects whether there is an arbitrage opportunity here,
and if there is, tells the company of how to take advantage of it, and calculates the payoff
in terms of present apples. The program should only need the bid and ask prices of each
of the dealers.

3) Explain the relationship between Arbitrage and the Law of One Price in financial mar-
kets. Compare the latter with examples of Law of One Price in other areas of economics,
and discuss the limitations of this so-called “law”.

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MARKING GUIDE FOR ASSIGNMENT 1
Criteria and weighting
1 Presentation: clear and precise
(15%)
2 Structure: clear and well
organised (20%)
3 Critical thinking and knowledge
applied to issues and ideas;
use of theory (65%)
ECON3107/5106 – Economics of Finance
Below expectations (F)
• Ideas not communicated clearly,
e.g. incorrect vocabulary/ grammar
• Unprofessional presentation, little
evidence of editing (e.g. many
spelling, punctuation errors)
• Verbose, expressed in more words
than are needed.
• Difficult to follow sequence of ideas;
unclear focus
• Text not clearly structured, e.g.
paragraphs not clearly developed.
• Does not clearly/correctly identify or
explain issues/problem
• Little analysis or critical evaluation
of ideas or information
• Struggles to appropriately apply
theory.
Meets expectations (P/Cr)
• Ideas generally communicated
clearly although could be more
effective
• An attempt at professional
presentation and editing: only
minor spelling/ punctuation errors.
• Sufficiently clear focus
• Mostly logical sequence of ideas.
• Adequately structured
• Identifies and defines key
issues/problems but does not
convey all aspects or complexity
• Some analysis of ideas or
information and application of
theory but with limited depth
Exceeds expectations (D/HD)
• Ideas communicated clearly and
fluently; mostly accurate
vocabulary/ grammar
• Ideas expressed concisely
• Very professional presentation –
evidence of thorough editing
(negligible errors)
• Ideas developed logically and
coherently
• Clear focus; no irrelevant material
• Well structured
• Clearly identifies and explains all
aspects of issues/problem and
conveys complexity of issue.
• Insightful analysis and critical
evaluation of ideas or information,
using appropriate theories and
showing depth of understanding