Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

14. Note that the Black-Scholes formula gives the price of European call c given the time to expiration T, the strike price K, the stocks

14. Note that the Black-Scholes formula gives the price of European call c given the time to expiration T, the strike price K, the stocks spot price S0, the stocks volatility , and the risk-free rate of return r : c = c(T, K, S0, , r). All the variables but one are observable, because an investor can quickly observe T, K, S0, r. The stock volatility, however, is not observable. Rather it relies on the choice of models the investor uses. The price of the option, c, if traded, is observable. So we can flip the problem around. Given observables T, K, S0, r and c, what volatility should the stock have in order for the Black-Scholes formula to be correct. This is called the implied volatility, BS. Some calculus, shows that BS exists and is unique.

The current spot price is $40, the expected rate of return of the stock is 8%, the risk-free rate is 3%. A European call option on the stock with strike price $40 expiring in 4 months is currently trading for $2. With trial and error, find a one-percentage point range which contains the implied volatility. So your answer should be of the form 14% BS 15%

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

A Practical Guide To Quantitative Finance Interviews

Authors: Xinfeng Zhou

1st Edition

1735028800, 978-1735028804

More Books

Students also viewed these Finance questions

Question

Draw a labelled diagram of the Dicot stem.

Answered: 1 week ago