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3) Assume that there are two possible future states of the economy: weak and strong....

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Finance

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3) Assume that there are two possible future states of the economy: weak and strong. Two securities, A and B, are available for trading. Prices (at t=0) and future payoffs (at t=1) in both states are given in the following table: Security Price ($) at t=0 Payoffs ($)at t=1 Weak state Strong state 0 200 100 0 A B 55.00 65.00 Assume that both states are equally likely (50% chance of each). Answer the following questions. a. There is another security, call it C, whose payoff at t=1 is equal to $300 in the weak state and $600 in the strong state. Find the no-arbitrage price (at t=0) of security C. (1 mark) b. What is the risk-free rate of return in this economy? (2 marks) Hint: create a portfolio that is risk-free. A portfolio is risk-free if its cash flow is guaranteed. c. What is the rate of return for security C? What is its risk premium? (2 marks)

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