Arrow-Debreu Pricing
a. What is the minimum number of Arrow-Debreu states needed to price: (i) a stock, (ii) a government bond, (iii) an at-the-money vanilla call on the stock, and (iv) a slightly out-ofthe-money vanilla put on the stock? CIRCLE ONE: 1 2 3 4 5 Impossible to answer
b. You are evaluating a really great stock with a current market price of $50. Over the next year, this stock could either double in value, or quadruple in value. Or it can go bankrupt. You can buy bankruptcy protection today for $0.50; this protection would pay you $1 in case the stock is worthless, and of course it pays you nothing if the stock doubles or triples.
The risk-free interest rate is 10%.
i. What is the probability of bankruptcy?
ii. What is the probability that the stock doubles?
iii. What is the probability that the stock quadruples?