Ans_Problem_Set_10__09

Ans_Problem_Set_10__09 - Princeton University Department of...

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Princeton University Department of Economics Economics 362 Fall Term 2009 Answers to Problem Set 10 1. a) To replicate a one-year pure discount bond with a face value of $100, buy a share of stock, and a European put with an exercise price of $100, and sell a European call with an exercise price of $100. b) S = $100, P = $15, and C = $35. X/(1+r) = S + P - C $100/(1+r) = $100 + $15 - $35 = $80 r = 100/80 - 1 = .25 or 25% c) If r = 10%, for instance, then one could make risk-free arbitrage profits by borrowing at 10% and investing in synthetic one-year pure discount bonds consisting of a share of stock, a European put with exercise price $100, and a short position in a European call with an exercise price $100. The synthetic bond would cost $80 and pay off $100 at maturity in one year. The principal and interest on the $80 it costs to buy this synthetic bond would be $80 x 1.1 = $88. Thus, there would be a pure arbitrage profit of $12 per bond a year from now with zero initial outlay of funds. 2.
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This note was uploaded on 01/15/2011 for the course ECO 362 at Princeton.

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Ans_Problem_Set_10__09 - Princeton University Department of...

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