Question: 4 consider a continuous time model on 0 t...
Question details
4. Consider a continuous time model on 0 ≤ t ≤ 1 in which the savings account rt rt
is given by βt =e^(rt) and the stock price is given by St =S0e^(rt) . The model also includes another random variable X that takes values from {0, 1}, indicating whether an earthquake has occurred at time 1. It is known at time 0 that the probability of the earthquake occurring at time 1 is strictly between 0 and 1. Only the stock and the savings account are traded.
-
(a) Does this model have arbitrage opportunities?
-
(b) Find two different equivalent martingale measures (EMMs) for this model. Using the fundamental theorems of asset pricing, what can you conclude about the model?
-
(c) Find a contract that cannot be replicated in the market.
Solution by an expert tutor
