Q 42. Two-State Option Pricing Model Maverick Manufacturing Ltd. must purchase gold in three months for use in its operations. Mavericks management has estimated that if the price of gold were to rise above $1,540 per ounce, the firm would go bankrupt.

The current price of gold is $1,460 per ounce. The firms chief financial officer believes that the price of gold will either rise to $1,625 per ounce or fall to $1,350 per ounce over the next three months. Management wishes to eliminate any risk of the firm going bankrupt. Maverick can borrow and lend at the risk-free EAR of 7.50 percent.

a) Suppose no options currently trade on gold. To create a synthetic option with identical payoffs to a traded option, you will need to buy some units of shares of stock and borrow some fund. How much do you need to borrow?

b) Suppose no options currently trade on gold. To create a synthetic option with identical payoffs to a traded option, you will need to buy some units of shares of stock and borrow some fund. How much does the synthetic option cost?