A zero-coupon bond promising to repay the principal of $1 at time 4 is available in the market. Today (time 1), the risk-free interest rate between time 1 and time 2 (denoted by r12) is constant at 0.02. However, the interest rates r23 and r34 are only known probabilistically at time 1. The interest rates and probabilities are as follows:
INTEREST RATES AND PROBABILITIES
|
r12 |
R23 |
R34 |
Risk- neutral Probability for each state |
|
0.07 |
0.09 |
0.6000 |
|
|
0.02 |
0.03 |
0.06 |
0.2000 |
|
0 |
0.04 |
0.2000 |