Question: Consider two nondividend-paying stocks whose time-t prices are denoted by S 1 (t) and S 2 (t), respectively. You are given: (i) S 1 (0)

Consider two nondividend-paying stocks whose time-t prices are denoted by S1(t) and S2(t), respectively.

You are given:

(i) S1(0) = S2(0) = 10.

(ii) Stock 1’s volatility is 25%.

(iii) Stock 2’s volatility is 25%.

(iv) The correlation between the continuously compounded returns on the two stocks is 1.

(v) The continuously compounded risk-free interest rate is 5%.

Consider a 1-year European option to exchange Stock 2 for Stock 1 at time 1.

Calculate the price of the exchange option.

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