Question
Consider a European call with an exercise price of 55 on a stock priced at 65. The stock can go up by 10 percent or
Consider a European call with an exercise price of 55 on a stock priced at 65. The stock can go up by 10 percent or down by 15 percent in each of two binomial periods. The risk-free rate is 5 percent. Determine the price of the option today. Then construct a risk-free hedge of long stock and short option (Assume that you sell 1,000 calls). At each point in the binomial tree, show the composition and value of the hedge portfolio and demonstrate that the return is the same as the risk-free rate. On any revisions to the hedge portfolio, make the transactions (buying or selling) in stock and not options. You can borrow any additional funds required at the risk-free rate, and any excess funds should be invested at the risk-free rate.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started