6. (Concept Problem) In this chapter, we obtained the binomial option pricing for- mula by hedging a
Question:
6. (Concept Problem) In this chapter, we obtained the binomial option pricing for- mula by hedging a short position in the call option with a long position in stock. An alternative way to do this is to combine the stock and a risk-free bond to repli- cate the call option. Construct a one-period binomial option pricing model in which the stock and a risk-free bond are used to replicate a European call option. Then show that the option pricing formula is the same as the one developed in the text. Hint: Hold n, shares of stock and issue B dollars of bonds paying r percent so that the value in both outcomes matches precisely the value of the option. Then solve for n, and B and substitute back into the formula for the value of the portfo- lio today to obtain the formula for C.
Step by Step Answer:
An Introduction To Derivatives And Risk Management
ISBN: 9780324321395
7th Edition
Authors: Don M. Chance, Roberts Brooks