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Consider a stock with a current price of P = $27. Suppose that over the next 6

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Consider a stock with a current price of P = $27. Suppose that over the next 6 months the stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call option on the stock with a strike price of $25 that expires in 6 months. The risk-free rate is 6%.

(1) Using the binomial model, what are the ending values of the stock price? What are the payoffs of the call option?
(2) Suppose you write 1 call option and buy Ns shares of stock. How many shares must you buy to create a portfolio with a riskless payoff (i.e., a hedge portfolio)? What is the payoff of the portfolio?
(3) What is the present value of the hedge portfolio? What is the value of the call option?
(4) What is a replicating portfolio? What is arbitrage?

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1 Current stock price P 27 Riskfree rate rRF 6 Strike price X 25 Up factor for stock price u 141 Down factor for stock price d 071 Years to expiration ...View the full answer


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Stocks (also known as equities) are securities that represent ownership in a company. They are issued by companies to raise capital, and when an individual buys stocks, they become a shareholder in that company. Investing in stocks can be a way for individuals to potentially earn a return on their investment through dividends and capital appreciation. However, investing in stocks also carries a level of risk, as the value of the stock can fluctuate based on various factors such as the financial performance of the company and general market conditions. For companies, issuing stocks can be a way to raise funds for growth and expansion. When a company goes public by issuing an initial public offering (IPO), it can raise significant capital by selling ownership stakes to the public. Companies can also issue additional stock offerings to raise additional capital as needed.

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