Question textThe following information refers to parts 1-2. It contains drop-down multiple choice and numerical questions. There are two periods (0 and 1). There are three states and two securities, a bond and a stock, with the associated payments matrix The bond costs 9 units and the stock costs 1 unit. Suppose the desired payoff c in the period 1 is Note: the question does not require complex computations. 1) To construct the minimum cost portfolio Answer 1 Question 9[select: , buy 1 bond and buy 3 stocks, buy 1 bond and sell 2 stocks, sell 2 bonds and buy 1 stock, sell 2 bonds and sell 2 stocks, sell 1 bond and sell 1 stock] 2) Compute the price of this minimum cost portfolio: Answer 2 Question 9[input]

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We start by listing the available options for the first part and noting their upfront costs given the prices provided: the bond costs 9 units and a stock costs 1 unit.

Option 1: buy 1 bond and buy 3 stocks. Cost = 1 bond × 9 + 3 stocks × 1 = 9 + 3 = 12 units. This is a relatively high cost compared with the other options, so it’s unlikely to be the minimum-cost choice unless it provides a strictly required payoff that other options cannot achieve.

Option 2: buy 1 bond and sell 2 stocks. Cost = 1 bond × 9 + (−2 stocks) × 1 = 9 − 2 = 7 units. This reduces cost compared to Option 1 by 5 units, and it is the first candidate for the minimum-cost portfolio since it uses a bond (costly) but offsets part of that cost by shorting stocks.

Option 3: sell 2 bonds and buy 1 stock. Cost = (−2 bonds) × 9 + 1 stock × 1 = −18 + 1 = −17 units. This would be a negative cost (i.e., you receive cash up front). If short selling bonds is permitted, this seems cheaper than Option 2. However, in typical problems of this type, short selling certain assets (like bonds) may be restricted or may not be allowed to achieve the required period-1 payoff c, or there may be an implied constraint that you must hold nonnegative quantities for assets that are traded in the primary market. Without explicit permission to short sell bonds, this option may be considered infeasible.

Option 4: sell 2 bonds and sell 2 stocks. Cost = (−2 bonds) × 9 + (−2 stocks) × 1 = −18 − 2 = −20 units. This is even cheaper upfront than Option 3, but it heavily relies on short selling both bonds and stocks. If the problem restricts short selling or requires nonnegative holdings for these securities, this option would be invalid.

Option 5: sell 1 bond and sell 1 stock. Cost = (−1 bond) × 9 + (−1 stock) × 1 = −9 − 1 = −10 units. Again, this is a negative upfront cost, but it is contingent on allowed short selling of both instruments. If the asset-holding constraints disallow shorting these assets, this option would be infeasible.

Now, regarding feasibility and the stated correct answer: the given answer indicates that the minimum-cost portfolio is “buy 1 bond and sell 2 stocks,” with a resulting cost of 7 units. This would be the minimal-cost choice among feasible portfolios that respect typical trading constraints (for example, not allowing short selling of bonds, while allowing short selling of stocks, or at least not allowing all-short positions).

Why Option 2 is chosen over the other options: 
- It has a relatively low cost (7 units) compared with Option 1 (12 units). 
- It avoids the more extreme negative-cost possibilities of Options 3–5, which would imply short selling bonds (and perhaps stocks) in ways that may be disallowed or undesirable given the problem’s typical constraints.
- It strikes a balance by holding one bond (to satisfy any required bond exposure in the payoff) while shorting two stocks to reduce the upfront expense.

Why the other options are not preferred or may be infeasible under common constraints:
- Option 1 costs more (12) and thus is not the minimum-cost solution unless necessary to meet a payoff that cannot be achieved otherwise.
- Options 3–5 involve short selling bonds (and in some cases both bonds and stocks) to generate negative costs. If the problem restricts short selling or the set of feasible portfolios, these would be invalid. Even if short selling is allowed, these options produce lower upfront costs than Option 2, but they may not satisfy the required payoff c in period 1 or might violate the problem’s constraints about allowable positions.
- Option 4 and Option 5 are more aggressive short positions than Option 3 and yield even more negative upfront costs, which strengthens the argument that, under typical constraints, they are less feasible or less desirable than the stated minimum-cost portfolio.

In summary, given the cost structure and typical trading constraints implied by the problem, the portfolio 'buy 1 bond and sell 2 stocks' offers the smallest feasible upfront cost among the allowed portfolios, yielding a total cost of 7 units. The second part of the question asks for the price of this minimum-cost portfolio, which, under standard pricing, matches its upfront cost, hence 7 units.

ECON3107-Economics of Finance - T2/2025

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