Suppose Microsoft stock sells for 100 while Netscape sells for 50. Three possible outcomes of a court case will have the following impact on the two stocks:

Microsoft Netscape

1 (win) 120 30

2 (draw) 110 55

3 (lose) 84 60

WhatshouldwebewillingtopayforanoptiontobuyNetscapefor50afterthecourt case is over? Answer this question in two ways: (i) ?nd a probability distribution so that the two stocks are martingales, (ii) show that by using cash and buying Microsoft and Netscape stock one can replicate the option.

6.5. Suppose Microsoft stock sells for 100 while Netscape sells for 50. Three possible outcomes of a court case will have the following impact on the two stocks: Microsoft Netscape 1 (win) 120 30 2 (draw) 1 10 55 3 (lose) 84 60 What should we be willing to pay for an option to buy Netscape for 50 after the court case is over? Answer this question in two ways: (i) nd a probability distribution so that the two stocks are martingales, (ii) show that by using cash and buying Microsoft and Netscape stock one can replicate the option