Now place yourself exactly in the same setting as before, where the market quotes the above R.
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The random event behind this bet is the same as in R. Now consider the following:
(a) Using the R and the Rˆ—, construct a portfolio of bets such that you get a guaranteed risk-free return (assuming that your friend or the market does not default).
(b) Is the value of the probability p important in selecting this portfolio? Do you care what the p is? Suppose you are given the R, but the payoff of Rˆ— when the incumbent wins is an unknown to be determined. Can the above portfolio help you determine this unknown value?
(c) What role would a statistician or econometrician play in making all these decisions? Why?
A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly...
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a If we buy R that is we bet on the incumbent winning and sell R that is we bet on ...View the full answer
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Related Book For 
An Introduction to the Mathematics of Financial Derivatives
ISBN: 978-0123846822
3rd edition
Authors: Ali Hirsa, Salih N. Neftci
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