Consider a world in which some stock, S, can either go up by 25% or down by 20% in one year and no other outcomes are possible. The continuously compounded risk-free interest, r, is 5.5% and the current price of the stock, S0, is $100.

(a) What are the possible stock values in one years time, ST?

(b) What are the possible payoffs of a European call option written on stock S with a strike price, X, of $100 and time-to-expiration of 1-year, T = 1?

(c) Suppose you want to form a portfolio, P, consisting of short on one call option and long on some number, , of the stock, such that the portfolio value in one years time, PT , does not depend on the value of the stock, ST. What would be the appropriate value of ?

(d) What would be the (certain) portfolio value in one years time, PT?

(e) What is the arbitrage-free value of the portfolio today, P0?

(f) What is the premium of the call option today, c0, if there is no arbitrage opportunity?

(g) Define p = (e rT d)/( u d), and call this the risk-neutral probability that the stock price increases. What is the value of p?

(h) What is the expected value of the stock in one years time, E(ST ), under the risk-neutral probabilities?

(i) At what continuous rate would the stock price have to grow to end up at the expected value?

(j) What would be the expected value of the call option in one years time, E(cT ), under the riskneutral probabilities?

(k) At what continuous rate would the call price have to grow to end up at the expected value?