Question: State Prices and Arbitrage There are two assets and three states. The risk free asset has an interest rate rf = 0. The risky asset

State Prices and Arbitrage

There are two assets and three states. The risk free asset has an interest rate rf = 0. The risky asset has rates of return r (0.1,0.0,0.1). a) Describe the possible vector or state prices, q. b) Proof that there are no arbitrage opportunities. c) Let 1 1 1 4 2 4 ( , , ) Describe the possible SDF vectors, m. d) Find the projection of the SDF vector onto the space of portfolio (gross) returns. What portfolio is this projection? (i.e., what fraction is held in the risky and risk-free assets?)

Question 2: State Prices and Arbitrage There are two assets and three

Question 2: State Prices and Arbitrage There are two assets and three states. The risk free asset has an interest rate r+= 0. The risky asset has rates of return r = (-0.1,0.0,0.1)'. a) Describe the possible vector or state prices, q. b) Proof that there are no arbitrage opportunities. c) Let =(4) Describe the possible SDF vectors, m. == d) Find the projection of the SDF vector onto the space of portfolio (gross) returns. What portfolio is this projection? (i.e., what fraction is held in the riskly and risk-free assets?)

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Lets go through each part of the question step by step Part a Describe the possible vector or state prices q To derive the state prices q q 1 q 2 q 3 q q 1 q 2 q 3 we use the fact that the price of a ... View full answer

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