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).