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Tutorial 2

The document discusses the economics of finance, focusing on the opportunity set for bonds and stocks related to an apple tree firm. It includes calculations for arbitrage-free prices, the impact of new securities on the market, and the theoretical concept of atomic (Arrow) securities. The tutorial provides practical exercises to analyze pricing and arbitrage opportunities in various scenarios.

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9 views1 page

Tutorial 2

The document discusses the economics of finance, focusing on the opportunity set for bonds and stocks related to an apple tree firm. It includes calculations for arbitrage-free prices, the impact of new securities on the market, and the theoretical concept of atomic (Arrow) securities. The tutorial provides practical exercises to analyze pricing and arbitrage opportunities in various scenarios.

Uploaded by

peterleewang
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Copyright c Copyright University of New South Wales 2025. All rights reserved.

Economics of Finance

Tutorial 2

1. An apple tree firm offers for sale a bond and stock. An apple tree produces 70GA and 45BA.
The bond pays 20GA and 20BA. The stock pays 50GA and 25BA. The price of the bond is 18PA,
and the price of the stock is 30PA.

(i) Construct and graph the opportunity set for future apples per present apple. Plot the bond and
stock on the opportunity set. Calculate the arbitrage-free atomic prices and also plot them on the
this means 1) all arrow security prices are positive
opportunity set.
2) no. of states = no. of assets (bond & Security)
3) payoff matrix has a non-zero determinant or an inverse exist
(ii) Holding the payments made by both the bond and stock in each state fixed, and the price of
the bond fixed, calculate the range of prices of the stock that generate positive prices for both the
atomic securities. (Hint: Observe the relative positions of the bond and stock on the graph, in
terms of security payoffs and prices).

(iii) A new security X appears on the market that pays 10GA and 35BA and has a price of 24PA.
Plot this security on the opportunity set. Does it provide any arbitrage opportunities? If so, design
a profitable arbitrage strategy.

(iv) Another security Y appears on the market that pays 50GA and 30BA and has a price of 40PA.
Plot this security on the opportunity set. Does it provide any arbitrage opportunities? If so, design
a profitable arbitrage strategy.

Atomic (Arrow) securities and arbitrage

Arrow security only apply in theory but not in real world


Atom -> basic element
In finance the most basic asset is called an atomic security. Also called an Arrow Security
Pay one unit of purchasing power in state S and 0 in all other states
For example, with 2 states and arrow security payoff vector in state 1 is (1,0) while the payoff vector in state 2 is (0,1)

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