Question 2

Suppose there are two economic states next year. The prices for the two states
are given by ( 1 , 2 ) = (0.35, 0.55). The payoff of a riskless bond in one year is
$100 in both states, that is, [$100,$100]. The payoff of a share of stock in one
year is [$150,$40].
(a) What is the bond price today?
(b) What is the stock price today?

Solutions:
(a) The price of the bond is:

PB = 0.35 ⇥ $100 + 0.55 ⇥ $100 = $90.

(b) The price of the stock is:

PS = 0.35 ⇥ $150 + 0.55 ⇥ $40 = $74.5.

Question 3
Let’s consider a state space model that has three states. There are three assets
traded in the market.
A riskless bond that pays $100 in each of the three states is currently traded at
$95. Stock 1 pays off [$250,$0,$500] and is currently traded at $150, and Stock
2 pays off [$0,$0,$500], and is traded at $100.
What are the state prices?

Solutions:
The pricing equation is:

P = 1 X1 + 2 X2 + 3 X3 .

Then for the three assets, we have:

95 = 1 ⇥ 100 + 2 ⇥ 100 + 3 ⇥ 100,

150 = 1 ⇥ 250 + 2 ⇥0+ 3 ⇥ 500,

100 = 3 ⇥ 500.
Solving this system of equations gives us the state prices: ( 1, 2, 3) = (0.2, 0.55, 0.2).