Question
You want to price a European call option on stock X, which currently trades at $40 per share (this stock does not currently pay dividends).
You want to price a European call option on stock X, which currently trades at $40 per share (this stock does not currently pay dividends). Suppose there are two possible outcomes for share prices of stock X next period: It can go up by 15%, or it can drop by 10%.
The option expires in one period, and has a strike price of $41. The risk-free rate over the next period is 5% (you can lend and borrow at the riskless rate). Markets are efficient and there are no arbitrage opportunities.
(a) What is the value of this call option today i.e., what is the call premium?
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