hw2 - sentence explain the risk associated with this...

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Math 489/889 Stochastic Processes and Advanced Mathematical Finance Homework 2 Steve Dunbar Due Monday, Sept 13, 2010 1. Consider the hypothetical country of Elbonia, where the government has declared a “currency band” policy. This means exchange rate between the domestic currency, the Elbonian Bongo Buck, denoted by EBB, and the US Dollar is guaranteed to fluctuate in a prescribed band, namely: 0 . 95USD EBB 1 . 05USD for at least one year. Suppose also that the government has issued 1- year bonds denominated in the EBB. The government is so shaky that it must pay a continuously compounded interest rate of 20%. Assuming that the corresponding continuously compounded interest rate for US lending and borrowing is 4%, show that there is an arbitrage opportunity. In a
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Unformatted text preview: sentence explain the risk associated with this transaction. 2. Consider a market that has (a) a stock (also called a security or asset), current price S (b) a loan market so that money (also called a bond) can be borrowed or loaned at an annual interest rate of r compounded continuously. At the end of a time period T , the security will either increase in value by a factor U to SU , or decrease in value by a factor D to value SD . Show that a forward contract with strike price k that, is, a contract to buy the security at time T with potential values SU-k and SD-k should have the strike price set at S exp( rT ) to avoid an arbitrage opportunity. 1...
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