1.Suppose security C pays $800 if the economy is weak and $200 if the economy is...
1.Suppose security C pays $800 if the economy is weak and $200 if the economy is strong. Risk free rate is 5% and the market index security (MIS) pay $800 and $1400 is the economy is weak and strong, correspondingly. MIS is priced at $950
a) what is no-arbitrage price of security C?
b) what is the expected return of security C?
c) what is the risk premium of security C?
Homework Answers
Answer:
(a).
Let p be the probability of weak econcomy and 1-p be the probability of strong economy
800*p+1400*(1-p)=950*1.05
=>p=0.671
Price of Security C=(800*0.671+200*(1-0.671))/1.05=573.81
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