Question: Consider a state-space model with two periods and three states at time t=1: 1,2, and 3. All three states are equally likely. Primitive state-contingent claims

Consider a state-space model with two periods and three states at time t=1: 1,2, and 3. All three states are equally likely. Primitive state-contingent claims on each state are traded in the market, and their time-0 prices are: 1=0.4, 2=0.3, 3=0.2. In addition to the primitive claims, the risk-free asset is traded.

a) Based on absence of arbitrage, what is the risk-free interest rate in this market?

b) Consider a cash flow C1 equal to $1, $2, and $4, in states 1,2, and 3, respectively. What is the expected value of the cash flow C1.

c) Compute the time-0 market value of the cash flow C1.

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