03rec1

# 03rec1 - MIT Sloan School of Management J Wang E52-456 15.407 Fall 2003 Recitation Notes Things to cover today Basic Concepts 1 No arbitrage 2

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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: (i) It is strictly increasing in all goods (ii) It is concave (people are risk averse)
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## This note was uploaded on 01/19/2011 for the course 15 15.407 taught by Professor Wang during the Fall '03 term at MIT.

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03rec1 - MIT Sloan School of Management J Wang E52-456 15.407 Fall 2003 Recitation Notes Things to cover today Basic Concepts 1 No arbitrage 2

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