Consider a firm whose stock price at the end of the year depends on the state of the economy (good or bad with equal probability) and the outcome of a lawsuit (win with probability 0.8 and lost with probability 0.2):

Win Lawsuit Lose Lawsuit

Good Economy $5.30 $3.30

Bad Economy $0.45 $0.20

The firm's current stock price (i.e., at the beginning of the year) is $2 per share. The riskless rate of interest is 10% per year.

(a) Form a tracking portfolio using the underlying stock and the riskless asset to evaluate a European call option on this stock, which expires at the end of the year with the strike price set equal to $3.5.

(b) Show that there are tracking errors in part (a). Why don't you worry about the tracking errors?