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What is the risk-neutral probability

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All interest rates are annual interest rates with semi-annual compounding. All coupon rates are annual rates paid semi-annually. Assume that today's 6-month spot rate is 9% and in six months the new 6-month spot rate can be either 5% or 13% with equal probability so that the expected 6-month spot rate six months from now is equal to 9%. Keep at least 7 decimal digits for all your calculations and answers.

a) Assume people are risk-neutral. Find the 1-year spot rate

b) If people are not risk-neutral and the 1-year spot interest rate is 9%, what is the risk-neutral probability of an "up" move (i.e., that the forward rate will be 13%)

c) Do you think people in part (b) are risk-averse or risk-loving?

Reference no: EM133060108

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