Bankruptcy Free Portfolio

FRM
#1

Hi all,

in Binomial Trees chapter it says that you can create a bankruptcy portfolio.

Stocks price today is 100. it would either go up in a year or go down, if it goes up it becomes 200 and if it goes down it becomes 50. now we can create a bankruptcy free portfolio if we invest present value of lower value of stock, i.e. PV of 50 today and invest rest i.e. (100- PVof 50) from our pocket,

in case stock price is 200 in a year, we receive - 200 -50(loan) = 150

in case stock price is 50, we receive 50-50(loan) = 0

payoff either 150 or Zero. but in my view it fails to account for rest of money put from pocket.

how is this a bankruptcy free portfolio in true sense ?? i am losing my investment in case price falls.

request anyone to throw some light on this pls. regards,

#2

The “bankruptcy-free” portfolio here means that you are able to pay off the borrowed money at the end of the period. So, in the example at page 71 (book 4), you will borrow $46.3 (50/1.08) and use your own fund of $53.7 to buy $100 stock. In the case when the stock drops to 50 at the end of period 1, you are still able to pay off your borrowed money “(avoiding bankruptcy filing).”

#3

hi Juz4fun,

Many thanks for your reply. Its clear if i view it as avoiding Bankruptcy.

May i ask you your advice to deal with Quantitative Analysis book. basically i am little weak in this subject.

i had difficulty in dealing with Quants in CFA Level 2 exam as well but i cleared it luckly.

Many thanks again.

#4

IMO, the SchweserNotes book 2:Quantitative Analysis is more than enough to get someone first quartile on this section based on my part 1 exam experience last May.

FYI, I used both Schweser and BT to prepare the part 1 exam.