You are considering an investment in a CAT bond. The CAT bond will mature in one year and will pay the face value of $100 with probability of 95% (which reflects the probability of no major hurricane) and nothing with probability of 5% (which reflects the probability of a major hurricane). The beta of the CAT bond is zero. The expected return on the market portfolio is 15%, and risk free rate is 2%.

a) The market price of the bond is such that you estimate its alpha to be 3%. What is the market price of the bond?

b) At what market price will you be indifferent between investing and not investing in the CAT bond?

c) Assume that the CAT bond is correctly priced. Suppose further the probability of a major hurricane was revised up from 5% to 6%. What would be the new fair price of the CAT bond? (