1. Bill is interested in buying a European call option written on ABC, a non-dividend paying common stock, with a strike price of $100 and one year until expiration. Currently, ABC stock sells for $80 per share. In one year, Bill knows the stock will be trading at either $110 or $60 per share. Bill is able to borrow and lend at the risk-free interest rate of 3 percent per annum (effective annual yield) How much should Bill expect to pay for his desired call option today? Explain. (6 pts)

Answer:

Su=10; Sd=0; Stock: Pu=110; Pd=60 borrow PV of 60 Su=50; Sd=0 Hedge ratio = 10/50 = 1/5 P call = 1/5*(80-60/1.03) = 4.35 ( Final answer )

Side: If put, strike = 100: Su = 0; Sd = 40 Stock: Su = 110; Sd = 60 short stock: Su = -110; Sd = -60; Lend: PV of 110 Su = 0; Sd = 110- 60 = 50 hedge ratio: 40/50 = 4/5 P put = 4/5*(110/1.03-80) = 21.44 Put call Parity: C+PV(K) = P+S: 4.35+100/1.03 = 101.43; 21.44+80 = 101.44

My question is : Can someone please explain to be me how this problem is solved step by step, I just want to learn ( I have limited Finance knowledge ) all context will help.