Consider an economy within there exit two securities; a stock and a bond, two state of nature, a growth and a recession, and two time periods; t = 0 and t = 1. The two states have equal chances of occurring. In the stock market, the stock sells for GHS 1.1 and pays a dividend of GHS 2 and GHS 1 at time; t = 1 in the growth and recession states respectively. The bond is associated with a pay - off of GHS 1 in both states and costs GHS 0.9 to purchase. Assuming that there is a possibility of long- and short-term positions in the security market. Given the pay - offs, find the combination of the two securities that will replicate the pay - off provided by the contingent claim for the good state; one in good state and zero in bad state. Find that combination that will give the pay - off provided by the contingent claim for the bad state; one in the bad state and zero in the good state. 

Required:

Determine the prices at which the contingent claims should sell at t = 0.

Answer rating: 100% (QA)

To determine the prices at which the contingent claims should sell at t 0 we need to find the weights of the stock and bond that replicate the desired payoffs in each state Lets denote the weight ... View the full answer