A European put option written on stock has strike price K = $21 and expires at...

  

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A European put option written on stock has strike price K = $21 and expires at time t = 1. At the current time t=0 the underlying stock has price S(0) = $20 and at expiry the price will be either S(1,1)= $24 or S(1,4)= $18. The interest rate over one timestep is r = 8%. (a) Show that there is no arbitrage opportunity. (b) Construct a replicating portfolio for this put option. Calculate Ho and H₁ for this replicating portfolio and thus find the value of the put at the current time P(0), correct to four decimal places. (c) By considering the values of Ho and H₁ you have obtained, explain what your replicating portfolio contains. A European put option written on stock has strike price K = $21 and expires at time t = 1. At the current time t=0 the underlying stock has price S(0) = $20 and at expiry the price will be either S(1,1)= $24 or S(1,4)= $18. The interest rate over one timestep is r = 8%. (a) Show that there is no arbitrage opportunity. (b) Construct a replicating portfolio for this put option. Calculate Ho and H₁ for this replicating portfolio and thus find the value of the put at the current time P(0), correct to four decimal places. (c) By considering the values of Ho and H₁ you have obtained, explain what your replicating portfolio contains.

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a No Arbitrage Opportunity To show that there is no arbitrage opportunity we need to demonstrate that its not possible to create a portfolio that guar... View the full answer