2. Assume you observe the following investment opportunities on the market: Security Market Index Security B...

 

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2. Assume you observe the following investment opportunities on the market: Security Market Index Security B Risk-free bond Market Price Weak Economy 700 1400 Strong Economy 1680 1400 The risk free rate is 2%. Investors demand a risk premium of 6% for investing in the market index. The probability for the economy to be weak is 50%. Required: 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! 2. Assume you observe the following investment opportunities on the market: Security Market Index Security B Risk-free bond Market Price Weak Economy 700 1400 Strong Economy 1680 1400 The risk free rate is 2%. Investors demand a risk premium of 6% for investing in the market index. The probability for the economy to be weak is 50%. Required: 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!