Q12

The Financial Institution APOLLON INC in the sunny State of California is implementing the latest risk HEDGING techniques. The Treasurer of the institution employs a Binomial Option Model in order to pay its obligations in the good, and the bad state of nature, respectively. However, the Treasurer Dr. Ding-Dong suffered a temporary lapse of memory and he forgot how to use this risk hedging technique.

1. Employ a call option of 11 dollars, a multiplicative upward factor of 1.5, a multiplicative downward factor of 0.7, a probability of 0.5 in every state of nature, a stock price of $110, and a striking price of $110 dollars respectively and create a PERFECT HEDGE. The Risk-Free Rate is 4%.

2. What is the Optimum Hedge Ratio?

3. What is the Optimum Hedge Strategy?

4. What are the intrinsic values of the option in the good and bad state of nature respectively?

5. Is the Call Option Overvalued or Undervalued?