Assume a one-period binomial model framework. You are given the following regarding Microsoft stock: Microsoft...

Transcribed Image Text:

Assume a one-period binomial model framework. You are given the following regarding Microsoft stock: • Microsoft share price currently sells for $60 per share. • Six months from now Microsoft share will sell for either $50 or $70 per share. • The continuously compounded risk-free interest rate is 7% per annum. The price of the risk-free asset is $1.00. • x is the number of shares in Microsoft stock. •y is the number of units in a risk-free asset. • Your analysis indicates that a six-month $65-strike European call option written on Microsoft stock is selling for $2.50. a) Construct a replicating portfolio h(x,y) at time 0 that will replicate the European call option after six months. b) Considering the value of a replicating portfolio in (a), create an arbitrage opportunity that will provide a profit after six months irrespective of whether Microsoft stock price increases to $70 or drops to $50. Assume a one-period binomial model framework. You are given the following regarding Microsoft stock: • Microsoft share price currently sells for $60 per share. • Six months from now Microsoft share will sell for either $50 or $70 per share. • The continuously compounded risk-free interest rate is 7% per annum. The price of the risk-free asset is $1.00. • x is the number of shares in Microsoft stock. •y is the number of units in a risk-free asset. • Your analysis indicates that a six-month $65-strike European call option written on Microsoft stock is selling for $2.50. a) Construct a replicating portfolio h(x,y) at time 0 that will replicate the European call option after six months. b) Considering the value of a replicating portfolio in (a), create an arbitrage opportunity that will provide a profit after six months irrespective of whether Microsoft stock price increases to $70 or drops to $50.

Answer rating: 100% (QA)

To solve this problem we will follow the principles of noarbitrage valuation and use the binomial model to value the option and construct a replicating portfolio In a oneperiod binomial model with two ... View the full answer