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Suppose there is only one future period and the presently known state of the world in that period can wither be s1 or s2. The future return on a share of a given company is 5 in state s1 and -1 in state s2. The future return on a govt. bond is 1 independent of the state. Suppose a third asset is offered on the market whose return is 3 in state s1 and 0 in state s2. The current prices of the stock and the bond are 3 and 1 respectively. If the price of the new asset rules out the possibility of arbitrage profit (which arises when portfolios of assets that are identical in terms of returns have different prices), what is the price of the new asset?
a. It depends on the probabilities of the future states.
b. Strictly between 2 and 3.
c. Strictly between 1 and 2.
d. 2
Answer is c. But how do we conclude that? Any help will be really nice. :)
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