Suppose the current price of a stock is $18. Consider a two state tree model defined...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
Suppose the current price of a stock is $18. Consider a two state tree model defined such that after 3 months, the stock price may increase to $19 with a 40% probability or decrease to $16 with a 60% probability. Consider a European call option, based on this stock, with strike price K=$17 and expiry time T = 3 months. Assume the risk-free interest rate is 9%. (a) (3 marks) Construct a risk-free portfolio and use it to determine the present no-arbitrage value (fair value) of the option (i.e., at time t = 0). (b) (3 marks) Suppose such an option is priced on the market at V* = 2.0 (i.e., higher than the no-arbitrage price). Describe the details for a strategy that will result in a guaranteed profit (in present value, i.e., at t = 0) and determine the value of that profit (per option), somewhat similar to what we did in class. (As usual in this course, we will assume short- selling is allowed and the no-arbitrage principle holds.) Suppose the current price of a stock is $18. Consider a two state tree model defined such that after 3 months, the stock price may increase to $19 with a 40% probability or decrease to $16 with a 60% probability. Consider a European call option, based on this stock, with strike price K=$17 and expiry time T = 3 months. Assume the risk-free interest rate is 9%. (a) (3 marks) Construct a risk-free portfolio and use it to determine the present no-arbitrage value (fair value) of the option (i.e., at time t = 0). (b) (3 marks) Suppose such an option is priced on the market at V* = 2.0 (i.e., higher than the no-arbitrage price). Describe the details for a strategy that will result in a guaranteed profit (in present value, i.e., at t = 0) and determine the value of that profit (per option), somewhat similar to what we did in class. (As usual in this course, we will assume short- selling is allowed and the no-arbitrage principle holds.)
Expert Answer:
Answer rating: 100% (QA)
a To construct a riskfree portfolio we need to determine the number of shares of the stock and the investment in the riskfree asset such as a bond Let... View the full answer
Related Book For
Financial Management Theory and Practice
ISBN: 978-0176517304
2nd Canadian edition
Authors: Eugene Brigham, Michael Ehrhardt, Jerome Gessaroli, Richard Nason
Posted Date:
Students also viewed these finance questions
-
KYC's stock price can go up by 15 percent every year, or down by 10 percent. Both outcomes are equally likely. The risk free rate is 5 percent, and the current stock price of KYC is 100. (a) Price a...
-
The current price of a stock is $100. A 1-year option on this stock has a strike price of $100. (a) Find the price of this option using the Black-Scholes model given that the risk-free rate is 5% and...
-
The current price of a stock is $94, and three-month European call options with a strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is...
-
The regression of the X and Y equation is Y = 48.32 -2.105X, What is the slope of the data.
-
Let X and Y be independent random variables with uniform densities in [0, 1]. Let Z = X + Y and W = X Y. Find (a) p (X, Y ) (see Exercise 18). (b) p (X,Z). (c) p (Y,W). (d) p (Z,W).
-
Corrosion fatigue in metals has been defined as the simultaneous action of cyclic stress and chemical attack on a metal structure. In the study Effect of Humidity and Several Surface Coatings on the...
-
Latin Cuisine is considering the purchase of new food processing technology, which would cost \(\$ 1,800,000\) and would generate \(\$ 300,000\) in annual cost savings. No salvage is expected on the...
-
Karen, in forming a new corporation, transfers land to the corporation in exchange for 100 percent of the stock of the corporation. Karens basis in the land is $275,000, and the corporation assumes a...
-
An Investor is considering the purchase of an existing suburban office building approximately five years old. The building, when constructed, was estimated to have an economic life of 50 years, and...
-
The Alfredo Fragrance Company produces only one product, a perfume called Hint of Elegance. Hint of Elegance consists of two secret ingredients blended into an exclusive fragrance, which is marketed...
-
The Wall Street Journal (Lippman, John, "The Producers: 'The Terminator' Is Back," March 8, 2002, A1) reported that Warner Brothers agreed to pay $50 million for its U.S. distribution rights, plus an...
-
What role does process simulation play in the optimization of energy and material efficiency in chemical processes, and how can simulation tools help identify bottlenecks and opportunities for...
-
Barry and Shirley have asked for an appointment to see your listing presentation and plans for the sale of their property. Prepare and deliver a listing presentation to the vendors. Be sure to: -...
-
Caldwell Home Appliances Inc. is estimating the activity cost associated with producing ovens and refrigerators. The indirect labor can be traced into four separate activity pools, based on time...
-
MacPherson Corp. has borrowed to invest in a project. The loan calls for a payment of $17,500 every quarter for eight years. The lender quoted MacPherson a rate of 4.84 percent with weekly...
-
Would others view you as an ethical leader? Please explain what traits you possess or behaviors you demonstrate (or the lack of) to support your reasoning of being an ethical leader. Please provide...
-
On May 1, 2019, Tumbler, Inc. bought a 3-year insurance policy for $12240 effective immediately. Assume that adjusting entries are prepared annually on the fiscal year- end on December 31. No more...
-
The area of square PQRS is 100 ft2, and A, B, C, and D are the midpoints of the sides. Find the area of square ABCD. B A
-
Maple Leaf Printing has $5 billion in assets, and its tax rate is 30%. Its basic earning power (BEP) ratio is 10%, and its return on assets (ROA) is 5%. What is Maple Leaf Printing's times-...
-
Assume that the risk-free rate is 5% and the market risk premium is 6%. What is the expected return for the overall stock market? What is the required rate of return on a stock that has a beta of 1.2?
-
AG Mechanical is planning to acquire Foster Metal works. Foster's cost of equity is 12%; it is financed 80% by common equity and the remainder by debt at 7%. Foster's tax rate is 30%. Below is a...
-
Parker Manufacturing, Inc., employs an overhead rate of 140% of direct labor cost. The Job 783 cost sheet shows that \($5,000\) in direct materials has been used and that \($8,000\) in direct labor...
-
What type of records would be used or maintained for the following manufacturing activities? a. Determining the amount of a specific material on hand b. Issuing direct materials for production c....
-
Why do we name it a predetermined manufacturing overhead rate?
Study smarter with the SolutionInn App