# Question

To answer this question, use the assumptions of Example 17.1 and the risk-neutral valuation method (and risk-neutral probability) described in Example 17.2.

a. Compute the value of a claim that pays the square root of the cash flow in period 1.

b. Compute the value of a claim that pays the square of the cash flow in period 1.

c. Given your answers above computed using risk-neutral valuation, back out the true discount rate that would give you the same value for each claim. In each case is this rate bigger or smaller than the 11% discount rate for the cash flow itself? Why?

a. Compute the value of a claim that pays the square root of the cash flow in period 1.

b. Compute the value of a claim that pays the square of the cash flow in period 1.

c. Given your answers above computed using risk-neutral valuation, back out the true discount rate that would give you the same value for each claim. In each case is this rate bigger or smaller than the 11% discount rate for the cash flow itself? Why?

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