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1. (5 marks) No-arbitrage option pricing. Suppose the current stock price is $20. A two state tree is defined such that after 3 months, the
1. (5 marks) No-arbitrage option pricing. Suppose the current stock price is $20. A two state tree is defined such that after 3 months, the stock price may increase to $22 with probability 0.1 and decrease to $18 with probability 0.9. Consider a European call option with strike, K=$21 and expiry T=3 months. The no-arbitrage value of the call option for today is given as $0.633 and interest rate = 12%. Suppose the option value V* > 0.633. Devise a strategy such that it will result in a positive profit of V* 0.633 (present value). 1. (5 marks) No-arbitrage option pricing. Suppose the current stock price is $20. A two state tree is defined such that after 3 months, the stock price may increase to $22 with probability 0.1 and decrease to $18 with probability 0.9. Consider a European call option with strike, K=$21 and expiry T=3 months. The no-arbitrage value of the call option for today is given as $0.633 and interest rate = 12%. Suppose the option value V* > 0.633. Devise a strategy such that it will result in a positive profit of V* 0.633 (present value)
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