tutorial7sol(1) - TUTORIAL 7 WEEK 8 ECON3107/ECON 5106...

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Unformatted text preview: TUTORIAL 7 WEEK 8 ECON3107/ECON 5106 Economics of Finance ANSWERS 1. (i) The return is obtained as r = ( c- p ) /p = c/p- 1. Since p is normalized to 1, r = c- 1. E ( r X ) = prob( B ) r X ( B ) + prob( G ) r X ( G ) = 0 . 4 . 10 + 0 . 6 0 = 0 . 04 The expected return on X is 4 %. E ( r Y ) = prob( B ) r Y ( B ) + prob( G ) r Y ( G ) = 0 . 4 - . 2 + 0 . 6 . 5 = 0 . 22 The expected return on Y is 22 %. (ii) The atomic prices are given by p atom = (1 1) 1 . 10 . 80 1 . 00 1 . 50- 1 = (0 . 5882 0 . 3529) . (iii) The discount factor is df = p B + p G = 0 . 9412 . Risk-free rate of return is1 /df- 1 = 0 . 0625. This is because if you buy one good and bad atomic security you are guaranteed one dollar in the next period. A portfolio that pays one dollar in each state can be found as follows: n = Q- 1 c = 1 . 10 . 80 1 . 00 1 . 50- 1 1 1 = . 8235 . 1176 . That is, you should invest $0.8235 in X and $0.1176 in Y. To obtain $K in each state you should invest K times these amounts in each security.K times these amounts in each security....
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This note was uploaded on 07/13/2011 for the course ECON 3107 at University of New South Wales.

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tutorial7sol(1) - TUTORIAL 7 WEEK 8 ECON3107/ECON 5106...

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