Question

Consider a one-period model with two risky assets s1 and s2. The prices of s1 and s2 will have the following three different scenarios. Suppose, in addition, that the risk-free interest rate is r. Which scenario refers to this model?

A) Various price scenarios for assets s1 and s2 with constant risk-free interest rate.
B) Fluctuating prices for s1 and s2 with no reference to the interest rate.
C) Price scenarios for assets s1 and s2 in a single-period model with a constant risk-free interest rate.
D) Fixed prices for s1 and s2 that disregard the risk-free interest rate.

Answer 1

The correct scenario is C, which involves price scenarios for assets with a constant risk-free interest rate within a one-period model, reflecting the aspects of risk and expected returns in investment decisions. The correct option is c.

Step-by-step explanation:

The scenario that best describes the one-period model with two risky assets, s1 and s2, and a constant risk-free interest rate is C) Price scenarios for assets s1 and s2 in a single-period model with a constant risk-free interest rate.

This scenario indicates that there are multiple outcomes for the prices of the assets, which represents the element of risk and uncertainty in their return, but amidst this, the risk-free interest rate remains constant.

This rate is an important factor for financial investors when considering the opportunity cost of investing capital and assessing the risk premium on investments. The expected rate of return, risk, and actual rate of return are critical components in making investment decisions.

Understanding these concepts helps investors decide how to price future payments, like bond yields, in response to fluctuating market interest rates, which thereby affects investment attractiveness and pricing. The correct option is c.