C1. A stock price is currently $100. Over each of the next two years it is expected to go up by 20% or down by 20%. The 1-year yield is 0.5%, and the 2-year yield is 1.5% (assume annual compounding).

a) What are the prices of Arrow-Debreu securities for the stock taking values of $64, $96, or $144 in two years?

b) What is the value of a 2 year European straddle with a strike of $95? Hint: try to price this using part (a) and not by calculating a put and a call separately.

c) Will the price in part (b) be higher or lower than at at-the money straddle? Why? You do not have to explicitly calculate the price of an at-the-money straddle to answer this question, but you can if it is helpful.

d) What would you to expect to change about your answers to part (b) if the 2-year yield was 0.5%? Why? Again, you do not have to calculate the price unless you find it helpful to do so.