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03rec1 - MIT Sloan School of Management J Wang E52-456...

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MIT Sloan School of Management J. Wang 15.407 E52-456 Fall 2003 Recitation Notes 9/18/2003 Things to cover today: Basic Concepts: 1. No arbitrage 2. Utility - Consumption choice 3. Risk Aversion PV: 1. Timing 2. Compounding 3. Annuity Definition of an Arbitrage: An arbitrage opportunity is a trade that gives you either (i) positive income today and non- negative payoff in the future; or (ii) a zero income today and a non-negative payoff in the future, with a positive probability of getting a strictly positive payoff. Examples of Arbitrage: (i) The 1 year (simple) interest rate is 5%, 2-year (simple) interest rate is 10%, but the 1-year forward rate 1-year from now is 5% (ii)You can buy 1-kg pack of rice for $10 from the supermarket, but someone is offering to buy rice from you for $1.2 per 100g. Examples of things that are NOT arbitrage: (i) A lottery that cost you $1, but have a 10% chance of paying you $15 (ii) GE is offering a 10-year bond with annual coupon of 10%, while government bond of the same life and is only paying a 5% annual coupon.
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Consumption Choice: Recap on utility What is utility function? Measures people’s ”satifaction” Assumptions about utility function:
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