1. You have the opportunity to invest in a security that produces the following risky cash...

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1. You have the opportunity to invest in a security that produces the following risky cash flows depending on the state of the economy. t=1 t=2 t=3 Strong Economy 155 184 170 115 144 130 Weak Economy The probability of a strong economy is 70%. Investing in the security will incur annual cost of EUR 16 for administration of the securities account. The risk-free interest rate is 2% and given the risk of the project, you demand a risk premium of 2%. The current price of the security is EUR 314.07. a) What is the expected cash flow of the security? b) What is the fair price of the security (=arbitrage-free price)? c) How can you exploit this arbitrage opportunity and what is the arbitrage profit you can realize today? 1. You have the opportunity to invest in a security that produces the following risky cash flows depending on the state of the economy. t=1 t=2 t=3 Strong Economy 155 184 170 115 144 130 Weak Economy The probability of a strong economy is 70%. Investing in the security will incur annual cost of EUR 16 for administration of the securities account. The risk-free interest rate is 2% and given the risk of the project, you demand a risk premium of 2%. The current price of the security is EUR 314.07. a) What is the expected cash flow of the security? b) What is the fair price of the security (=arbitrage-free price)? c) How can you exploit this arbitrage opportunity and what is the arbitrage profit you can realize today?