question archive Consider a two period "perfect capital market" setting w/ uncertainty
Consider a two period "perfect capital market" setting w/ uncertainty
Subject:FinancePrice:2.86 Bought15
Consider a two period "perfect capital market" setting w/ uncertainty. Namely under t=2 "good economy" and "bad economy" will occur with equal chance. Everybody has the same information.
No cheating etc. Consider two securities X and Y with the following promised time2 payoffs and time1 prices. Recall that in this economy anybody promising to pay 100TL under good
Time 2 good Security X Security Y
Time 2 bad 100 TL 200 TL
Time 1 price 70 TL 140 TL
80 TL 170 TL
Answer the following question:
a) Are the two time1 prices in harmony or are they out of line?
b) Is there any basis to think that one of them is "cheap" and the other is "dear"?
c) Can you make a profit by selling the "dear" one and simultaneously buying two of the "cheap" one?
d) ?f your answer to ©? is YES, Explain how it would work at t=1 and t=2
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Given that god and bad economy will occur with equal chance i.e. probability p is 1/2
|
Security X |
Security Y |
|
|
Price (Good Economy) at t2 |
100 |
200 |
|
Price (bad Economy) at t2 |
70 |
140 |
|
Expected Price at t2 (Σpi*xi Where p is the probability and x is the price) |
85 |
170 |
|
Piece of Security at t1 |
80 |
170 |
a. Prices of Security at t1 are not in harmony as, from the above table, it can be seen that on average or the expected price of security X at t2 is more than price at t1 where as it remains same for Security Y.
b. Security Y is priced at premium or is “dear” compared to Security X as explained above.
c. We can make profit by buying the 2 items of Security X (cheap one) and Selling one item of Security Y (dear one) as detailed below
d. i) At t1, buy two items of Security X at 160 (2*80) and sell one item of Security Y at 170 with price difference of 10.
ii) At t2, the two items of Security X are priced/can be sold at 170 (2*85) same as security Y
iii) Depending on the other Costs (like cost of debt etc). there is potential gain of 10 for each above mentioned transaction.
