APPLIED STOCHASTIC PROCESSES FOR FINANCE

HOMEWORK 1, SOLUTION
Peter Lakner

(a) Below is the tree for the discounted prices:

We need to satisfy G () 0 for every and G () > 0 for at least one . We get the
following three inequalities, corresponding to each :
H1 H2 0
H1 + H2 0
1.5H2 0
The left-hand side of the first inequality is minus one times the left-hand side of the second.
The only way both can be greater than of equal to zero if both are equal to zero, that
is, H1 = H2 . Then 1.5H2 must be positive which will be true whenever H2 is negative.
A possible solution to this is H1 = H2 = 1. We select H0 so that the initial wealth V0
becomes 1.
1 = V0 = H0 + 2H1 + 2H2 = H0 2 2 = H0 4.
This gives H0 = 5.
This strategy requires shorting one share of each stock and putting $5 that the investor
receives at time zero in the bank.
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(b) Here is the tree for the value process (V0 , V1 ):

(c) Here is the tree for the discounted value process:

(d) Gains: (.1, .1, 1.75)

(e) Discounted gains: (0, 0, 1.5)