Question
We know the prices and payoffs for securities 1 and 2 and they are represented asfollows: Security 1 2 Market Price Today $110 $130 Cash
We know the prices and payoffs for securities 1 and 2 and they are represented asfollows:
Security
1
2
Market Price Today
$110
$130
Cash Flow in One Year
Weak Economy
$0
$250
Strong Economy
$250
$0
a. What is therisk-free interestrate?
b. Consider arisk-free security that has a payoff in one year of $2,750.
i. How many units of each of securities 1 and 2 would be needed to replicate thisrisk-free
security?
ii. Based on part b.i), what is the market price today of thisrisk-free security?
iii. Based on part a), what is the market price today of thisrisk-free security?
c. Consider a security that has a payoff in one year of $2,750 if the economy is weak and $5,500 if the economy is strong.
i. How many units of each of securities 1 and 2 would be needed to replicate this
security?
ii. Based on partc.i), what is the market price today of thissecurity?
d. Consider a security that has a payoff in one year of $5,500 if the economy is weak and $2,750 if the economy is strong.
i. How many units of each of securities 1 and 2 would be needed to replicate this
security?
ii. Based on partd.i), what is the market price today of thissecurity?
e. Explain the economic reasoning as to why the security in partc) has a lower price than the security in partd).
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