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Stochastic Interest Rate Models

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  • Stochastic Interest Rate Models

    The question reads as follows:
    On average a company earns interest on its funds at 10% p.a. However in any year the yield of the company's funds is equally likely to take on a value between 8% and 12%.
    In return for a single payment of 1 735.50, the company offers an investor a payment of 1 000 at the end of each year for 2 years.
    Calculate the expected value at the end of the contract of the company's accumulated profit.
    Calculate the standard deviation of the accumulated profit.

    I have managed to calculate E[accumulated profit] = -0.045
    But I am not sure where to begin to calculate the standard deviation, so any help will do!
    Thanks

  • #2
    Show your work on how you came up with your expected profit.

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    • #3
      this is a binomial tree that does not recombine. At any given point for any tree,
      u/d=e^(2sigma*sqrt(h)) You are given u and d, so you can solve the equation.
      "As far as I'm concerned, I prefer silent vice to ostentatious virtue." Albert Einstein
      "It is hard to tell if a man is telling the truth when you know you would lie if you were in his place." H. L. Mencken

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