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Question 1 The stock price of HM changes only once a month: either it goes up by 20% or it falls by 16.7%. Its price
Question 1 The stock price of HM changes only once a month: either it goes up by 20% or it falls by 16.7%. Its price now is $40. The risk free rate is 12% per year (approximately 1% per month): a) What is the value of a one-month call option with an exercise price of $40? Use both the risk-neutral and hedge portfolio approaches to value this option. b) What is an option delta? What does it mean? c) Show how the payoffs of this call option can be replicated by buying HM's stock and borrowing. d) Calculate the price of the above call option. e) Imagine that we are talking now about the equivalent put option. Compute the price of this option using both hedge portfolio and risk-neutral valuation and comment on the replicating strategy
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