Question 2 [Pricing Kernel]

You have estimated the pricing kernel using market option data:

State	Likelihood	m / SDF	ABC Cash-flow
A	1/3	0.9	20
B	1/3	0.98	10
C	1/3	1.05	5

A. [4 pts] What is the price, expected return and expected excess return (above the risk-free rate) of ABC?

B. [2 pts] Using the pricing kernel, compute the price of a call option with a strike price of 11.

c. [4 pts] An exotic option will pay the square of the ABC cash-flow. That is, if ABC pays $3, this option will pay $9 (3²=9). What should be the price of this option? Explain why the pricing kernel approach is convenient for pricing exotic options as compared to the binomial model in this example.