Exercise 3

In the third exercise session, we worked with one-period securities-market models. We practised discounting by the bank account and computing portfolio values and ordinary and discounted gains. We identified arbitrage opportunities and used attainable payoff vectors to test the law of one price. We also discussed why a positive expected return alone does not constitute arbitrage.

Exercise set:

• Exercise Set 3

Solution set:

• Solution set for Exercise 3

Material used:

• Pliska, Sec. 1.1, Model Specifications, pp. 1–3; Sec. 1.2, Arbitrage and Other Economic Considerations, pp. 4–10.

Exercise Set 4 for Thursday 24 September