Market Price ($) |
Cash Flow in One Year ($) |
||
Security |
Today |
Poor Economy |
Good Economy |
A |
450 |
800 |
0 |
B |
300 |
0 |
800 |
C |
??? |
4000 |
800 |
1.
Security C can be constructed by buying 5 unit of Security A and 1
unit of Security B
Hence, Price of Security C=Price of 5 units of Security A+Price of 1 unit of Security B=450*5+300*1=2550.00
2.
Let risk free rate be p
Let probability of poor economy be p and probability of good
economy be 1-p
From Security A: 800*p/(1+r)=450
From Security B: 800*(1-p)/(1+r)=300
Solving the two simultaneously, we get
p/(1-p)=450/300
=>1/p-1=300/450
=>1/p=300/450+1
=>p=1/(300/450+1)
and r=800/(300/450+1)*1/450-1=6.6667%
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