Question 2 [7 marks]

You are thinking of buying a European put option on shares in a company called ABC. The current price of one ABC share is $30, and over the next month the share price will either increase to $37.5 or decrease to $28.8.

The European put option will expire at the end of one month. The strike price is $31.5. The share will not pay any dividends during the next month. You can borrow money today for one month at the rate of j12 = 5.8% p.a.

1. [6 marks] Consider the replicating portfolio (i.e., the investment strat- egy which will give identical payoffs, at the end of one month, to the put option), that involves buying h shares in ABC today, and borrowing $B for one month. Find the values of h and B. (Round your answers to five decimal places.). Illustrate this model in a carefully labelled contingent cash flow diagram.

2. [1 mark] What is the initial cost (i.e., net outlay) today of investing in the replicating portfolio? (Round your answer to five decimal places.)