An investor is given the following information. Security J K State 1 (s=1) 12 24 Payoff...

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An investor is given the following information. Security J K State 1 (s=1) £12 £24 Payoff State 2 (s=2) £20 £10 Market prices P₁= £22 Px= £20 a) Explain the concept of pure securities. How would the investor use pure securities to replicate the payoff of security J? b) What are the prices of pure security 1 and pure security 2? c) What is the initial price of a third security I, for which the payoff in state 1 is £6 and the payoff in state 2 is £10? d) Suppose a risk-free asset that pays £1 exists. Can pure securities replicate its payoff? Calculate the risk free rate using the law of one price. e) Can a portfolio of securities J and K provide the same payoffs as the risk free asset in d) (we may buy fractions of shares)? f) Suppose an investor has initial wealth of £900. They can short sell securities; however, they must be able to meet all claims under the occurrence of either state. What is the maximum number of security I they could sell (short selling) to buy security K? (they may buy fractions of shares)? An investor is given the following information. Security J K State 1 (s=1) £12 £24 Payoff State 2 (s=2) £20 £10 Market prices P₁= £22 Px= £20 a) Explain the concept of pure securities. How would the investor use pure securities to replicate the payoff of security J? b) What are the prices of pure security 1 and pure security 2? c) What is the initial price of a third security I, for which the payoff in state 1 is £6 and the payoff in state 2 is £10? d) Suppose a risk-free asset that pays £1 exists. Can pure securities replicate its payoff? Calculate the risk free rate using the law of one price. e) Can a portfolio of securities J and K provide the same payoffs as the risk free asset in d) (we may buy fractions of shares)? f) Suppose an investor has initial wealth of £900. They can short sell securities; however, they must be able to meet all claims under the occurrence of either state. What is the maximum number of security I they could sell (short selling) to buy security K? (they may buy fractions of shares)?

Answer rating: 100% (QA)

a Pure securities are financial instruments with known future payoffs in specific states of the world and they are used to replicate the payoffs of ot... View the full answer