Imagine a financial market with one zero-coupon bond and one stock. The risk-free rate of interest over
Question:
Imagine a financial market with one zero-coupon bond and one stock. The risk-free rate of interest over one period of time is r = 25% and the initial value of the stock is S0 = $10. There are two possible states of the world at t = 1, say ?up? and ?down,? and the stock takes values
Now a call option on the stock is introduced into the market. Its payoff function is
with exercise price K = $13. Compute the risk neutral probabilities and the fair price C0 of the derivative contract.
(15 if w=1 S1(w) = 15 if w = Į. |C = max(Sj – K,0)
Step by Step Answer:
The risk neutral probabilities can be calculated as pup r dd...View the full answer
Related Video
A call option is a type of financial contract that gives the holder the right, but not the obligation, to buy an underlying asset (such as a stock, commodity, or currency) at a specified price (called the strike price) within a specified period of time. When an investor purchases a call option, they are essentially betting that the price of the underlying asset will rise above the strike price before the option\'s expiration date. If the price of the asset does rise above the strike price, the investor can exercise the option by buying the asset at the strike price and then selling it at the higher market price, thereby earning a profit. Call options are often used as a speculative investment strategy, as they allow investors to potentially profit from the upward movement of an asset without having to actually own the asset itself. They are also commonly used as a hedging tool to protect against potential losses in a portfolio.
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