Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Could you please help me complete the proof of Case II ? Thank you. Theorem 1 (NAP) implies a > r > 01'. Proof. Begin

Could you please help me complete the proof of Case II? Thank you.

image text in transcribed
Theorem 1 (NAP) implies a > \"r > 01'. Proof. Begin by noticing that if a" > u > til, then the safe asset's payoff per unit invested always exceeds the payoff of the risky asset. This implies that the safe asset dominates the risky asset no investor who prefers more cash (in each state) to less will EVER choose to invest in this risky asset. Likewise, if u > d > r > 0, the risky asset [per unit) dominates the safe asset. Hence, we can conne attention to showing it > '1" > d must hold when the (NAP) obtains. Suppose the condition (NAP) is true, but the conclusion of the theorem is false. This means (NAP) holds, (1 > u and r 2 I] hold, but d 2 r. In this case, there will be an arbitrage portfolio. This contradiction implies the theorem is true. Thus, the main argument is to construct an arbitrage portfolio assuming it > a" Z r. The first step is to nd the possible zero net outlay portfolios. These are combinations of 2: and y such that $80 + an = 0'. This restriction implies there are two possible cases: Case I: a: > 0 and y = mSn/Bg. This is a long position in the stock and a short position in the bond (borrowing money). Case II: 3,! > 0 and 1: = yBu/SO. This is a long position in the bond (lending money} and a short position in the stock

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Rethinking Macroeconomics

Authors: John F McDonald

2nd Edition

1000434699, 9781000434699

More Books

Students also viewed these Economics questions