Question
The price of 1 share of BKM stock today is S(0) = 100. At the beginning of next year, the price will either increase to
The price of 1 share of BKM stock today is S(0) = 100. At the beginning of next year, the price will either increase to uS(0) or decrease to dS(0), where u = 1.25 and d = 0.8. The riskless interest rate for one period is r = 0.25. Consider a European call option with an exercise price of K = 100 that allows the owner of the option to buy 1 share of BKM stock in period 1. Also consider a European put option with an exercise price of K = 100 that allows the owner of the option to sell 1 share of BKM stock in period 1.
(i) Briefly explain what is meant by arbitrage.
(ii) Carefully explain how arbitrage can be used to calculate the market value of the call option described above.
(iii) Suppose now that an investor has a portfolio consisting of 1 call option and 1 put option where these options are those that were described at the beginning of the question. What is a numerical estimate of the market value of the investor's portfolio? Explain your reasoning.
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