PROBLEM SET

5.1 Security A pays $30 if state 1 occurs and $10 if state 2 occurs. Security B pays $20 if state 1 occurs
and $40 if state 2 occurs. The price of security A is $5 and the price of security B is $10.

a) Set up the payoff table for securities A and B.

The payoff table for securities A and B is as shown below.

Payoff
State 1 State 2 Security prices
Security A 30 10 5
Security B 20 40 10

b) Determine the prices of the two pure securities.

P1QA1 + P2QA2 = PA
P1QB1 + P2QB2 = PB
Substituting the values for the payoff table, we get:
30 P1 + 10 P2 = 5
20P1 + 40P2 = 10
Dividing the second equation by 4 we have:

30 P1 + 10 P2 = 5
5P1 + 10P2 = 2.5
25P1 = 2.5 => Therefore P1 = 0.1
from the first equation:
30 P1 + 10 P2 = 5; but P1 is 0.1
3 + 10P2 = 5
10P2=2 => Therefore P2=0.2

First pure security P1=0.1