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Q 2. The current price of a stock is $30. We assume that in 1 year, the stock price will be either $33 or $27
Q 2. The current price of a stock is $30. We assume that in 1 year, the stock price will be either $33 or $27 with physical probabilities 60% and 40%, respectively. The risk-free rate r is 5%. We want to price a European call written on this stock with strike K = 30 and maturity T = 1 year. (a) Compute the call option price using the physical probabilities. [1 marks) (b) Compute the call option price using the risk-neutral probabilities. [3 marks (c) Show that if the option is traded at a price different than the price in (b), then there is an arbitrage. In particular, specify a static portfolio that meets the definition of arbitrage (which you are to verify, using the type-l condition). 4 marks (d) Does the above result mean that the physical probabilities are irrele- vant to option pricing? Justify your answer. [2 marks]
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