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Assume that there are two possible future states of the economy: weak and strong. Two securities, A and B, are available for trading. Prices (at t=0) and future payoffs (at t=1) in both states are given in the following table:
Security
Price ($) at t=0
Payoffs ($)at t=1
Weak state
Strong state
A 50.48 0 200
B 70.00 100 0
Assume that both states are equally likely (50% chance of each). Answer the following questions.
Question a. There is another security, call it C, whose payoff at t=1 is equal to $200 in the weak state and $400 in the strong state. Find the no-arbitrage price (at t=0) of security C. (1 mark)
Question b. What is the risk-free rate of return in this economy? Hint: portfolio that is risk-free. A portfolio is risk-free if its cash flow is guaranteed.
Question c. What is the rate of return for security C? What is its risk premium?
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