Question
A financial instrument will pay off as follows: Probability 50% 25% 12.5% 6.25% 3.125% 3.125% Payoff $100 $110 $130 $170 $250 $500 A. What price
A financial instrument will pay off as follows:
Probability | 50% | 25% | 12.5% | 6.25% | 3.125% | 3.125% |
Payoff | $100 | $110 | $130 | $170 | $250 | $500 |
A. What price today would make this a fair bet?
B. What is the maximum price that risk-averse investor would be willing to pay?
C. Now assume that the financial instrument costs $100. What is its expected rate of return?
D. If the prevailing interest rate on time-equivalent treasuries is 10%, and if financial default happens either completely (i.e. no repayment) or not at all (i.e. full promised payment), then what is the probability p that the security will pay off? In other words, assume that full repayment occurs with probability p and that zero repayment occurs with probability 1-p. What is the p that makes the expected rate of return equal to 10%?
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