Suppose that we can describe the world using two states and that two assets are available, asset K and asset L. We assume the assets’ future prices have the following distributions:
State | Future Prices Asset K | Future Prices Asset L
1 | $25 | $21
2 | $20 | $27
Let K(1) = $20 denote the time 0 price of asset K and L(1) = $19 the time 0 price of asset L.
(a) Assuming no arbitrage opportunities, what are the values of the unit claims, at time 0?
(b) What is the risk-free rate of return that must exist in this market?