Describe how a risk-free hedge portfolio can be created using stocks and options.

How can such a portfolio be used to help estimate a call option’s value?

What is a replicating portfolio, and how is it used to find the value of a derivative security?

What is arbitrage?

Lett Incorporated’s stock price is now $50, but it is expected either to rise by a factor of 1.5 or fall by a factor of 0.7 by the end of the year. There is a cell option on Lett’s stock with a strike price of $55 and an expiration date 1 year from now What are the stock’s possible prices at the end of the year? ($75 or $35) What is the cell option’s payoff if the stock price goes up? ($20) If the stock price goes down ? ($0) If we sell 1 call option, how many shares of Lett’s stock must we buy to create a riskless hedged portfolio consisting of the option position and the stock? (0.5) What is the payoff of this portfolio? ($17.80) If the annual risk-free rate is 6%, then how much is the riskless portfolio worth today (assuming daily compounding)? ($16.48) What is the current value of the call option? ($8.52)