Z = 7.8

Suppose there are four possible states of the world in the next period, denoted by good weather (GW), fair weather (FW), bad weather (BW) and awful weather (AW). Also, four securities are available on the market with payoffs in each state listed below. 45 40 GW FW BW AW Bond Stock 1 Stock 2 Stock 3 10 40 10 31 35 53 10 27 25 31 10 19 20 32 The prices of the four securities are as follows: PBond = 2 + 7, PStock 1 = 25, Pstock 2 = 30 and PStock 3 = 48. (1) Show how to construct a portfolio that makes the following time-state payments exactly: GW 0 FW 30 BW 10 AW 20 Feel free to use any method of your choosing to answer this question. (Hint: a portfolio of just two securities can replicate these time-state payments exactly) Suppose there are four possible states of the world in the next period, denoted by good weather (GW), fair weather (FW), bad weather (BW) and awful weather (AW). Also, four securities are available on the market with payoffs in each state listed below. 45 40 GW FW BW AW Bond Stock 1 Stock 2 Stock 3 10 40 10 31 35 53 10 27 25 31 10 19 20 32 The prices of the four securities are as follows: PBond = 2 + 7, PStock 1 = 25, Pstock 2 = 30 and PStock 3 = 48. (1) Show how to construct a portfolio that makes the following time-state payments exactly: GW 0 FW 30 BW 10 AW 20 Feel free to use any method of your choosing to answer this question. (Hint: a portfolio of just two securities can replicate these time-state payments exactly)