Consider a two-period, two-state world. Let the current stock price be 45 and the risk-free rate be 5 percent. Each period the stock price can go either up by 10 percent or down by 10 percent. A call option expiring at the end of second period has an exercise price of 40.

Construct an example showing how the hedge works and illustrating how the hedge portfolio earns the risk-free rate in each period.

Answer rating: 100% (QA)

To make the portfolio riskless hedge we need to Long 011 shares against ... View the full answer