Question

Trinomial tree model

A company is seeking finance for a treasure adventure. It is estimated that there is a 0.25 probability of high success, p2 0.5 probability of moderate success and p0.25 probability of failure. The company hence issues the following two securities: each cost one dollar with the following terminal values: (a) $2.00 if the adventure is a high success, S1.00 if moderate success, and $0.00 if failure (b) $5.00 if high success, $0.00 otherwise Also on the market there is a third security: (c) a 10% risk-free return. Based on these three securities, find the risk neutral probability. (Hint: Let , 2 bhe corre- sponding risk neutral probability. Find an equation syste by using the fact that the discounted security price is a martingale under the risk neutral probability.)