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Suppose that the process for S1 follows equation (25.26) (McDonald, 2013, p.632) with dividends ...

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Finance

Suppose that the process for S1 follows equation (25.26) (McDonald, 2013, p.632) with dividends = 0: dS1 = 1S1dt +1S1dZ1. Consider an asset that follows the process: dS2 = 2S2dt 2S2dZ2. Show that (1 r)/1 = (2 r)/2 has to hold, as otherwise an arbitrage opportunity exists. (Hint: Find a zero-investment position in S1 and S2 that eliminates risk.)

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