A $100 Face Value One-Year Risk-Free Discount Bond Is Priced $\{ 99.74,94.74,89.74 \}$

question 14

Multiple Choice

A $100 face value one-year risk-free discount bond is priced at $95. The two-year discount bond is priced at $90. After one year, the two-year bond will take one of three possible prices with defined probabilities. Which of the following sets of prices is acceptable from a no-arbitrage standpoint?

• A) \(\{ 99.74,94.74,89.74 \}\) with equal probabilities.
• B) \(\{ 99.74,94.74,89.74 \}\) with probabilities \(\{ 0.25,0.50,0.25 \}\) .
• C) Both (a) and (b).
• D) The problem is not well-defined because there is no unique martingale probability measure for the two-year bond.

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Definitions:

Machine-sewn Products

Goods that are manufactured using sewing machines, often implying mass production and consistent quality.

Wage Rate

The amount of money paid to an employee per unit of time, such as an hour or a week.

Capital

Refers to financial assets or the financial value of assets, such as cash and investments, as well as physical assets like machinery or buildings, used in the production of goods and services.

Fixed Proportions

A production scenario where inputs are used in a constant ratio, regardless of the level of output.