Exercise 7

In the seventh exercise session, we worked with predictable trading strategies, self-financing rebalancing, and discounted gains. We computed local risk-neutral probabilities on a two-step tree and combined them into a martingale measure. We also checked the no-arbitrage criterion and constructed an arbitrage strategy when a local condition failed.

Exercise set:

• Exercise Set 7

Solution set:

• Solution set for Exercise 7

Material used:

• Pliska, Sec. 3.1.3, Trading Strategies, pp. 80–81; Sec. 3.1.4, Value Processes and Gains Processes, pp. 81–82; Sec. 3.1.5, Self-Financing Trading Strategies, pp. 82–83; Sec. 3.1.6, Discounted Prices, pp. 83–84; and Sec. 3.4, Economic Considerations, pp. 92–99.

Exercise Set 8 for Thursday 22 October