Question 5 [20 marks in total] Consider a one-period investment model where each investor chooses her position (holdings

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Question 5 20 Marks In Total Consider A One Period Investment Model Where Each Investor Chooses Her Position Holdings 1 (257.3 KiB) Viewed 84 times

Question 5 [20 marks in total] Consider a one-period investment model where each investor chooses her position (holdings) at Date 0 and receives payouts at Date 1. There are m > 1 states at Date 1 and n > 1 securities currently available for trading at Date 0. Let A be the mxn matrix whose (i, j) entry is the price of Security j in State i of Date 1. The market is called complete if the rank of A is m. Now suppose that a new security is added with payout vector v, so the ith entry of the mx1 matrix v is the price of the new security in State i. The new security is called redundant if its payout can be replicated by a holding of the existing securities; in other words, the security is redundant if v is a linear combination of columns of A. 1. [5 marks] (SF) Give an example where a new security is NOT redundant. Pick your own m, n, A and v. 2. [5 marks] (Medium) Show that if the market is complete without the new security, then the new security is necessarily redundant. 3. [10 marks] (Medium) Now assume that the following three securities already exist in the market: Security B pays 1+r in every state, Security S pays yi in State i for each i, and Security C pays max{yi – K, 0} (the larger number between yi – K and 0) in State i for each i. Here r, yi, ..., Ym and K are known positive numbers. To avoid uninteresting situations, we assume that some yi are greater than K while some are smaller than K. The market may contain other securities but may not be complete. Now a new security P is introduced, which pays max{K – Yi,0} in State i for each i. Show that P is redundant: it can be replicated by some combination of B, S and C. The number of states m is large; for concreteness you may take m = 100 even though the result we want to derive holds for every m. If you find it helpful, you may assume that yı