A stock price is currently trading at 40. Paul Tripp, CFA wants to value one-year index option using the single-period binomial model. The stock will either increase in value by 20% with probability of 40% or fall in value by 30% with

probability of 60%. The annual risk-free interest rate is 2%. No dividends are paid on any of the underlying securities in the index.

a. Calculate the value of a European call option on the index with an exercise price of 40

b. Combine the call options from questionawith T-bills and the underlying stock in the way that the payoff of the resulting portfolio becomes the same as a payoff of a long straddle with the call option from question a. Find the position in each security in this portfolio.