(answer IIIa)The price at t=0 is equal to 0: V0 =α S0+βM0=1-1=0. At t=1 we have:
- V1,u =α S1,u+βM1=1.1 - 1 x 1.05 =0.06;
- V1,d =α S1,d+βM1=1.07 - 1 x 1.05 =0.02.
So there is a free lunch without risk. The reason for this, of course, is that even in the down scenario the stock earns more than you need to pay on your debt with the bank (10% > 7% > r = 5%).
(answer IIIb) This question is answered in Tutorial 3