A trader is considering purchasing several Arrow-Debreu securities which all have the same maturity time, but...

 

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A trader is considering purchasing several Arrow-Debreu securities which all have the same maturity time, but provide a payoff of $1 at all possible states of the maturity time. The trader thinks that this is a very clever investment plan, and is possibly an arbitrage opportunity because it ensures there is always a payoff of $1. Here we investigate the trader's investment plan using a two-step binomial pricing model. Assume that the return on an investment over one time-step is constant R and the risk-neutral probability of the upstate is T. In a two-step model, derive a formula for the total premium of all the Arrow-Debreu securities (that is, derive formulas for the premiums of each Arrow-Debreu security and then add them together). Given your answer in Question above, describe a portfolio which is a replicating portfolio of the sum of all Arrow-Debreu securities. Confirm that this portfolio is a replicating portfolio by showing that at each node it equals the sum of all Arrow- Debreu securities. A trader is considering purchasing several Arrow-Debreu securities which all have the same maturity time, but provide a payoff of $1 at all possible states of the maturity time. The trader thinks that this is a very clever investment plan, and is possibly an arbitrage opportunity because it ensures there is always a payoff of $1. Here we investigate the trader's investment plan using a two-step binomial pricing model. Assume that the return on an investment over one time-step is constant R and the risk-neutral probability of the upstate is T. In a two-step model, derive a formula for the total premium of all the Arrow-Debreu securities (that is, derive formulas for the premiums of each Arrow-Debreu security and then add them together). Given your answer in Question above, describe a portfolio which is a replicating portfolio of the sum of all Arrow-Debreu securities. Confirm that this portfolio is a replicating portfolio by showing that at each node it equals the sum of all Arrow- Debreu securities.

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To derive a formula for the total premium of all the ArrowDebreu securities in a twostep binomial pricing model we can first calculate the premium for ... View the full answer