1. Assume the following investment opportunities on the market shown in Table 1. They gen- erate...

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1. Assume the following investment opportunities on the market shown in Table 1. They gen- erate a certain cash flow in t = 1, which depends on the state of the economy. Security Market Index Security B Market Price Weak Economy Strong Economy 733.00 1,605.00 Risk-free bond 1,402.00 1,402.00 Table 1: Economy The risk-free rate is 2%. Investors demand a risk premium of 7% for investing in the market index. The probability for the economy to be weak is 50%. a) Compute the arbitrage-free prices of the market index and the risk-free bond! b) Design the cash flow of security B in a way that a portfolio of the market index and security B replicate the cash flow of the risk-free bond! c) Compute the arbitrage-free price of security B! d) What is the expected return of security B? 1. Assume the following investment opportunities on the market shown in Table 1. They gen- erate a certain cash flow in t = 1, which depends on the state of the economy. Security Market Index Security B Market Price Weak Economy Strong Economy 733.00 1,605.00 Risk-free bond 1,402.00 1,402.00 Table 1: Economy The risk-free rate is 2%. Investors demand a risk premium of 7% for investing in the market index. The probability for the economy to be weak is 50%. a) Compute the arbitrage-free prices of the market index and the risk-free bond! b) Design the cash flow of security B in a way that a portfolio of the market index and security B replicate the cash flow of the risk-free bond! c) Compute the arbitrage-free price of security B! d) What is the expected return of security B?