Lecture 10

Now this mean a portfolio 1052 252 gives you arrow

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Unformatted text preview: ice that neither security dominates the other; Security 1 pays off better than 2 in State 1 and Security 2 pays off better in State 2 than Security 1. Now, This mean a portfolio 10/52, 2/52 gives you Arrow security that pays off 1 unit of State 1 purchasing power and nothing in State 2: i.e., ₁ 6 4 ₂ 2 10 1, in State 1, and 0. , Likewise, the portfolio 1: ₁ 6 ₂ 4 0, and 10 2 pays out the 1 unit in State 2 and 0 units in State 1. Using the same example, it is easy to see that by purchasing 6 units of Arrow security 1 and 2 units of Arrow security 2, one would obtain the ordinary security 1 (with payoff of 5 units in state 1 and 2 units in state 2). Likewise, 4 units of Arrow security 1 and 10 units of Arrow security 2 replicates the ordinary security 2. Now pick any state‐contingent return r, say 2,8 . We know we could get this return, as stated above, by purchasing 2 units of Arrow security 1 and 8 units of Arrow security 2. But we could also synthesize this return by using the ordinary returns above. We form this portfolio by usi...
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This document was uploaded on 02/07/2014.

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