Section 4 - ECON 136: Financial Economics Section 4 (Sep...

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Unformatted text preview: ECON 136: Financial Economics Section 4 (Sep 18th) Xing Huang 1 Economics Department, UC Berkeley 1 Dynamic Trading 1.1 De&nition & It is possible to have fewer assets than &nal states of the world but still be able to create a full set of Arrow-Debreu securities. In other word, dynamic trading can complete markets when there are fewer assets than there are &nal states of the world. & Trading strategy: purchase a portfolio at t = 0 which pays o/ at t = 1 , then invest the payo/ in another portfolio that pays o/ at t = 2 . and then invest the payo/ in another portfolio that pays o/ at t = 3 ...... so on and so on. & Creating Arrow-Debreu securities in a dynamic trading environment: Work backwards through the event tree and create AD securities as before at every node. The resulting synthetic AD security will be a dynamic replicating portfolio of the existing assets that involves trading at intermediate dates. 1.2 Example In The Big Game the possible outcomes are as follows: & In the &rst half Cal can go ahead by 10 points or Stanford can go ahead by 10 points. & In the second half the change in the score can be 10 points in Cals favor or 10 points in Stanfords favor. Suppose there are bookmakers who allow you to bet at the start of the game on the half-time score. & The cost of a bet that pays $1 if Cal is ahead at half time is $0.80....
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This note was uploaded on 01/25/2010 for the course ECON 136 taught by Professor Szeidl during the Fall '08 term at University of California, Berkeley.

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Section 4 - ECON 136: Financial Economics Section 4 (Sep...

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