The Following Simple Two-Country Question Illustrates How Countries Are Made

question 75

Essay

The following simple two-country question illustrates how countries are made better off by trade in assets. Imagine that there are two countries, Home and Foreign, and that residents of each own only one asset, domestic land yielding an annual harvest of kiwi fruit. Assume that the yield on the land is uncertain. Half the time, Home's land yields a harvest of 100 tons of kiwi fruit at the same time as Foreign's land yields a harvest of 50 tons. The other half of the time the outcomes are reversed. The Foreign's harvest is 100 tons, but the Home harvest is only 50.
-Suppose the two countries can trade shares in the ownership of their perspective assets. Further assume that a Home owner owns a 25 percent share in Foreign land. He will receive 25 percent share in Foreign land and thus receives 25 percent of the annual Foreign kiwi fruit harvest. Further assume also that a Foreign owner of a 25 percent share in Home land is permitted. In this case, a Foreigner is entitled to 25 percent of the Home harvest. Calculate the expected value of kiwi fruit for each investor.

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Definitions:

Time To Expiration

The duration remaining until the expiry of a contract, particularly relevant for options and other derivatives.

Call Option

A financial contract giving the buyer the right, but not the obligation, to buy an asset at a specified price within a certain time frame.

Exercise Price

The predetermined price at which the holder of an option can buy or sell the underlying asset.

American Put Option

A financial contract that gives the holder the right to sell a specified amount of an underlying asset at a predetermined price before or at the expiration date.