Consider two securities, X and Y. The total return for each unit of X and each...
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Consider two securities, X and Y. The total return for each unit of X and each unit of Y depends on the interest rate at the end of the year. An economist predicts the following scenario: Security X Y State of nature Rate increases Rate decreases 3 1 2 4 3.1 Determine the states prices 1 and 2 for each state. 3.2 Do arbitrage opportunities exist? Justify your answer. 3.3 Show that the initial price of the security X is equal to one unit. Suppose that H is another security in the market an the total return of H is also determined by the interest rate. If the interest rate increases, the total return of H is 2 and if the interest rate decreases, the total return of H is 4. What is the price of H? Consider two securities, X and Y. The total return for each unit of X and each unit of Y depends on the interest rate at the end of the year. An economist predicts the following scenario: Security X Y State of nature Rate increases Rate decreases 3 1 2 4 3.1 Determine the states prices 1 and 2 for each state. 3.2 Do arbitrage opportunities exist? Justify your answer. 3.3 Show that the initial price of the security X is equal to one unit. Suppose that H is another security in the market an the total return of H is also determined by the interest rate. If the interest rate increases, the total return of H is 2 and if the interest rate decreases, the total return of H is 4. What is the price of H?
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Answer rating: 100% (QA)
ANSWER 1 State prices represent the probabilities assigned to each state of nature To determine the state prices we need to normalize the probabilitie... View the full answer
Related Book For
Contemporary Financial Management
ISBN: 9780324289114
10th Edition
Authors: James R Mcguigan, R Charles Moyer, William J Kretlow
Posted Date:
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