A market has two stocks S1 and S2. Both S1 and S2 are valued at $1 per unit today and can be worth either $2 or $0.5 per unit after one year.

A market has two stocks S1 and S2. Both S1 and S2 are valued at $1 per unit today and

can be worth either $2 or $0.5 per unit after one year. Assume that money M valued at $1

per unit today does not change its value during that time.

(a) Suppose a convertible bond B that pays either $2 when S1 = $2 or $1 when

S1 = $0.5 in a year is also traded in the market.

(i) Calculate the portfolio (S1;M) that replicates B using matrix inverses.

(ii) Calculate the price of convertible bond B.

(b) Suppose an option O1 that pays $1 when both S1 = S2 = $2 (and 0 otherwise)

is traded in the market and is worth $0.125. Also suppose option O2 that pays $1 when

S1 = $2 but S2 = $0.5 (and 0 otherwise) is traded in the market as well.

(i) Calculate the portfolio (S1;S2;M;O1) that replicates O2 using row reduction.

(ii) Calculate the price of option O2.