Company A is currently suing company B for IP infringement. Their stock prices currently are pA = $10 and pB = $8. If A wins the lawsuit, its stock will go up to $15 and B’s stock will drop to $5. If A loses, however, its stock will be worth $9, and B’s stock will rise to $10. Neither stock pays dividends. Assume no arbitrage and consider whether A wins or not to represent the only two states of the world.

a. Calculate the Arrow-Debreu security prices, qA-wins and qA-loses.

b. If there is a riskless asset in the economy that pays $1 in both states, what would the price of such asset be? What would be the riskless interest rate?

c. Now suppose there actually is a “riskless bond” in the economy that offers a 5% interest rate between now and when the outcome of the lawsuit is announced. Is there an arbitrage opportunity? If so, how might you trade to exploit it? (Note the asset we priced in part b is not assumed to exist, nor are Arrow Debreu securities.)