Consider a markov chain with transition matrices for the, Ask an Expert

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Consider a Markov chain with transition matrices for the first three time periods given by

1940_Transition Matrix.png

Interest rates are given by i0 = 0.05, i1 = 0.06, i2 = 0.07. Find the APV of each of the following contracts.

(a) At time 0, the process is in state 0. A contract provides for payments at the end of the period of a transfer from state 0 to state 1 if this occurs within three periods. The payment is 100 in the first year, 200 in the second year, and 300 in the third year. Note that more than one payment can be made.

(b) At time 0 the process is in state 0. A contract provides for a payment of 1000 at time k, k = 0, 1, 2, 3, provided the process is in state 0 at time k.

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