Consider the tree in Table 9.10. You estimated the risk neutral probability to move up the tree to be p* = 1 / 2.

(a) Compute the value of the zero coupon bonds maturing at time i = 1 and at i = 2.
(b) Compute the continuously compounded yields for both bonds.
(c) Compute the value of an option with payoff
Option Payoff at 1 = 100 ( max(r1 - 4%,0)
(d) Set up the replicating portfolio that uses the bond prices determined in Part (a), that is able to replicate the option's payoff. Check that this portfolio in fact replicates the option.
(e) Given the tree for the option, set up a replicating portfolio made of the short-term bond and the option that is able to replicate the prices of the long-term bond at time 1, that is, P1, u(2) and Pi,d(2)?

period time (in years) t # 0 t 0.5 r1,-: 4% | r1.d 1% | with prob. p-| /2 2% with prob. I-p 1/2 period time (in years)0 with risk neutral prob. p 1/2 Ea-3% with risk neutral prob. 1-p 1/2