Question: 1. Consider a model with only one time period. Assume that there exist a stock and a cash bond in the model. The initial price

1. Consider a model with only one time period. Assume that

1. Consider a model with only one time period. Assume that there exist a stock and a cash bond in the model. The initial price of the stock is $60. The investor believes that with probability 1/5 the stock price will drop to $30 and with probability 4/5 the stock price will rise to $80 at the end of the time period. The cash bond has an initial price of $90 and it will with certainty deliver $100 at the end of the period. Use the replication principle and find a price of a European call with a maturity at the end of the time period and a strike price of $40. Is this price fair? Explain your answer. Find the price using risk neutral probabilities. Comment on the equivalence of the two approaches. 1. Consider a model with only one time period. Assume that there exist a stock and a cash bond in the model. The initial price of the stock is $60. The investor believes that with probability 1/5 the stock price will drop to $30 and with probability 4/5 the stock price will rise to $80 at the end of the time period. The cash bond has an initial price of $90 and it will with certainty deliver $100 at the end of the period. Use the replication principle and find a price of a European call with a maturity at the end of the time period and a strike price of $40. Is this price fair? Explain your answer. Find the price using risk neutral probabilities. Comment on the equivalence of the two approaches

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