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Problem 1 (10 points): Assume that today’s 6-month spot rate is 9% and in six months the new 6-month spot rate can be either 5% or 13% with equal probability so that the expected 6-month spot rate six months from now is equal to 9%. Keep at least 7 decimal digits for all your calculations and answers. a) (4 points) Assume people are risk-neutral. Find the 1-year spot rate b) (4 points) If people are not risk-neutral and the 1-year spot interest rate is 9%, what is the risk-neutral probability of an “up” move (i.e., that the forward rate will be 13%) c) (2 points) Do you think people in part (b) are risk-averse or risk-loving?

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