QUESTION $2(12$ marks$)$

Use the table for questions a$-$c below.

a$)$ What is the risk$-$free rate in this economy? Why is this the risk$-$free rate? $(3$ marks$)$

b$)$ What is arbitrage? What is an arbitrage opportunity? $(2$ marks$)$

c$)$ What is the no$-$arbitrage price for security C$?(2$ marks$)$

Use the following information for questions d$-$f$.$

A bond promises a risk$-$free payment of $$1000$ in one year. The risk$-$free rate of interest is $3\mathrm{.}5\%$ per year,

compounded annually.

d$)$ What is the price of the bond? $(1$ mark$)$

e$)$ If the price of the bond is actually $$960,$ what is the arbitrage strategy? Illustrate all cash flows at time $0$

and at time $1.(2$ marks$)$

f$)$ If the price of the bond is actually $$970,$ what is the arbitrage strategy? Illustrate all cash flows at time $0$

and at time $1.(2$ marks$)$