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1. (40 marks) Consider a one-period model (a period is one year) formed by a bond paying a risk-free rate of 4% per year, and
1. (40 marks) Consider a one-period model (a period is one year) formed by a bond paying a risk-free rate of 4% per year, and by Stocks 1 and 2 with initial prices so = 7.8 and s = 7, respectively, and S(wi) = 18, S/(w2) = 15, S/(W3) = 3 and Siwi) = 10, S}(wa) = 8, S (W3) = 6, with probabilities Plwi), P(w2), P(3) >0 and P(wi) + P(W2) + PW3) = 1. (a) (10 marks) Is the market free of arbitrage? (You need to give your reason.) (b) (10 marks) Is the market complete? (You need to give your reason.) (c) (10 marks) Consider a contingent claim X with contract function X = (S1, ) = max S - S 0 and P(wi) + P(W2) + PW3) = 1. (a) (10 marks) Is the market free of arbitrage? (You need to give your reason.) (b) (10 marks) Is the market complete? (You need to give your reason.) (c) (10 marks) Consider a contingent claim X with contract function X = (S1, ) = max S - S
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