University of Geneva - HEC

Advanced Finance
Fall 2014
Problem Set 3

Instructions:

• Please hand in your answers at the beginning of lecture on Thursday, December 18th , 2014. No late
submissions will be accepted.

• Please hand in one solution set for each group.

• Please write legibly, in capital letters, the surnames and first names of each member in the group,
at the upper left corner of the first page of your answer sheet.

• Your answers need to be succinct and to the point; you might get penalized for long-winded answers.
Your handwriting also needs to be clearly legible.

• Please justify all your answers, even in multiple-choice questions. I will give no credit for answers
without an explanation.

• The problem set will be graded out of 100. The number of points that each problem is worth is
written in brackets.

1
1 Identifying Arbitrage [10 points]
 
2 0  
  1
Consider a market with payoff matrix A = 1 1, and price vector S =  . Decide whether there
 
  1001
0 2
are any arbitrage opportunities in this market, and if so, try to identify them by constructing a type I
or type II arbitrage portfolio x. If there is no arbitrage, give a vector of strictly positive state prices
consistent with the price vector of basis assets.

2 Consumption CAPM and State Prices [10 points]

Which of the following statements is correct?

a. The state price for a state is small when the true probability of the state occurring is high.

b. The stochastic discount factor is high when the personal discount factor β is low.

c. The state price for a state is high when the marginal rate of substitution for that state is high.

d. All of the above.

e. None of the above.

3 Competitive Equilibrium [10 points]

Think of an Edgeworth box diagram. Which of the following statements is correct?

a. An equilibrium allocation, if it exists, is in the set of Pareto efficient allocations.

b. A Pareto efficient allocation is such that the indifference curves of the two agents through that point
are tangent.

c. If the initial allocation of assets is not Pareto efficient, then it is definitely possible to increase the
utility of one investor, without decreasing the utility of any other investor.

d. (a) and (b) are correct

e. All of the above.

2
4 Pareto Set [10 points]

Consider an Edgeworth Box representation of an economy with two investors. Pareto Optimal allocations
in the Edgeworth Box are:

a. Points where the two investors’ indifference curves are tangent.

b. Points where the Marginal Rates of Substitution of the two individuals are equal.

c. Points representing allocations where one investor cannot be made better off without making the
other investor worse off.

d. All of the above are true.

e. None of the above.

5 Competitive Equilibrium [20 points]

Assume there are 2 investors (A, B) and 2 states (1, 2). Additionally, assume:

• Initial endowments are:

– Investor A has 12 units of the Arrow-Debreu security for state 1, and 2 units of the Arrow-
Debreu security for state 2.

– Investor B has 8 units and 18 units of the two Arrow-Debreu securities, respectively.

• Preferences are as follows:

– For investor A, we know that u xA A A

A

x2 , where xA A


1 , x2 = x1 1 and x2 are the quantities of

A-D security for state 1 and 2, respectively, that he owns.

– For investor B, we know that u xB B B

B

x2 , where xB B


1 , x2 = x1 1 and x2 are the quantities of

A-D security for state 1 and 2, respectively, that he owns.

Draw the Edgeworth box, showing the initial allocation. Is the initial endowment allocation Pareto
efficient?

3
6 Asset Pricing in One-period Model [40 points]

Consider a model with 1 period and 4 states of the world. Consider the following assets:

1. A risk-free bond with return 1 on both borrowing and lending. Its price at t = 0 is 1.

2. A risky stock, whose return can be 0.5, 1, 1.5, or 2. Its price at t = 0 is 2.

3. A call option on the stock, with strike price 2. Its price at t = 0 is 0.5.

4. A put option on the stock, with strike price 2.

a. Consider first a market in which only the bond, stock, and call option are traded.

i. Is the market complete?

ii. Explain why there is or there is not arbitrage in this market. If there is arbitrage, how would
you exploit it?

b. Consider now that a bank introduces the put option in the market. At what price should it be sold?

c. Consider now that the bank has chosen to introduce the put option in the market, and sell it at a
price of 1. Explain why there is or there is not arbitrage in this market. If there is arbitrage, how
would you exploit it?

d. Consider now a market in which the only traded assets are the risk-free asset and the stock (with
payoffs and prices as above), together with another stock whose price is 2, and whose return is 0.25,
0.5, 1, and 3 when the return on the first stock is 0.5, 1, 1.5, and 2, respectively. You can safely
assume that there is no arbitrage in this market. Find the no-arbitrage price of the portfolio that is
the best approximate hedge for the digital call option on an “index” of the two stocks, with payoff

D = 1 if the sum of the stocks’ returns is above 2

D = 0 otherwise