29 Two-state Option Pricing Model Ken is interested in buying a European call option written on Southeastern Airlines plc, a non-dividend-paying equity, with a strike price of £110 and one year until expiration. Currently, Southeastern’s equity sells for £100 per share. In one year Ken knows that Southeastern’s shares will be trading at either £125 per share or £80 per share. Ken is able to borrow and lend at the risk-free EAR of 2.5 per cent.

(a) What should the call option sell for today?

(b) If no options currently trade on the equity, is there a way to create a synthetic call option with identical payoffs to the call option just described? If there is, how would you do it?

(c) How much does the synthetic call option cost? Is this greater than, less than or equal to what the actual call option costs? Does this make sense?