Question: Consider the three state, two security example Security 1 Security 2 Probability State Price Recession Normal Boom 90 80 100 0 0.2 100 100

Consider the three state, two security example Security 1 Security 2 Probability State Price Recession Normal

Consider the three state, two security example Security 1 Security 2 Probability State Price Recession Normal Boom 90 80 100 0 0.2 100 100 0.5 100 200 0.3 (a) What is the risk-free rate that is implied by the price of security 1? (b) What is the expected return of security 2? (c) Suppose we introduce Security 3, which pays 0 on both the Recession and Normal states and pays 300 in a boom. Is the market complete? (d) For what values of P3 is there no arbitrage?

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