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tutorial7-1 - Why are the forward prices and associated...

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TUTORIAL 7– WEEK 8 ECON3107/ECON 5106 – Economics of Finance 1. Two securities X and Y make the following payments (for each dollar invested) in the good and bad weather states: X Y B 1 . 10 0 . 80 G 1 . 00 1 . 50 Suppose the good outcome occurs with probability 0.6 and the bad outcome with probability 0.4. (i) Compute the expected rate of return on securities X and Y. (ii) Compute the atomic security prices. (iii) Compute the risk-free rate of return. Construct a portfolio of securities X and Y that pays the same amount in the good and bad states. (iv) Compute the expected rate of return and risk premia of the atomic securities. (v) Compute the forward prices of the atomic securities (risk neutral probabilities). (vi) Compare the forward price of each atomic security with the probability of that state being observed.
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Unformatted text preview: Why are the forward prices and associated probabilities not equal? 2. Consider the portfolio Z that makes the following payments in four different states (VB, B, G, VG). You are also given (physical) probabilities and forward prices (risk neutral probabilities) of each state c prob f VB 60 . 3 . 5 B 10 . 2 . 3 G 10 . 1 . 1 VG 50 . 4 . 1 Suppose the risk-free rate of return is 5 percent. (i) Compute the risk premium of portfolio Z. (ii) Compute the risk premia of the four atomic securities. (iii) Will the market portfolio pay a risk premium in this case? Explain. Note : Do not submit this tutorial assignment, since it will not be marked. 1...
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