Lecture02OnePeriodModel.pptVIP

Lecture 02: One Period Model;Overview;The Economy;Security Structure;One A-D asset e1 = (1,0);Add second A-D asset e2 = (0,1) to e1 = (1,0);Arrow-Debreu Security Structure in R2;Arrow-Debreu Security Structure in R2;Arrow-Debreu Security Structure;General Security Structure;General Security Structure;Add security (2,1) to bond (1,1);Portfolio of buy 3 bonds sell short 1 risky asset;;Portfolio: vector h 2 RJ (quantity for each asset) Payoff of Portfolio h is ?j hj xj = h’X Asset span X is a linear subspace of RS Complete markets X = RS Complete markets if and only if rank(X) = S Incomplete markets rank(X) S Security j is redundant if xj = h’X’ with hj=0 ;Price vector p 2 RJ of asset prices Cost of portfolio h, If pj 1 0 the (gross) return vector of asset j is the vector ;Options to Complete the Market;Options to Complete the Market;Overview;Pricing;Vector Notation;Three Forms of No-ARBITRAGE;Law of one price is equivalent to every portfolio with zero payoff has zero price. No arbitrage ) no strong arbitrage No strong arbitrage ) law of one price ;Pricing;LOOP ) q(h’X) = p ￠ h A linear functional Q in RS is a valuation function if Q(z) = q(z) for each z 2 X. Q(z) = q ￠ z for some q 2 RS, where qs = Q(es), and es is the vector with ess = 1 and esi = 0 if i 1 s es is an Arrow-Debreu security q is a vector of state prices ;State prices q;q1;The Fundamental Theorem of Finance;Multiple State Prices q  Incomplete Markets;q;q;q;Multiple q in incomplete markets;Uniqueness and Completeness;The Three Asset Pricing Formulas;Stochastic Discount Factor;X;Price of any asset Price of a bond ;The Three Asset Pricing Formulas;specify Preferences Technology;Suppose that ST, the price of the underlying portfolio (we may think of it as a proxy for price of “market portfolio”), assumes a continuum of possible values. Suppose there are a “continuum” of call options with different strike/exercise prices ) markets are complete Let us construct the following portfolio: