A share now sells for $110. The price will either increase 10% (by a factor of u = 1.10) or decrease 5% (by a factor of d = 0.95) over a six-month period. A European call option on this share has an exercise price of $110 and a time to expiry of six months. The risk-free rate is 10.0% per year. 

a. Draw tree-diagrams to show the possible paths of the share price and call price over a six month period. Show the numbers that are known and use letter(s) for what is unknown in your diagrams. 

b. Compute the hedge ratio. 

c. Show how to form a perfect hedge using the hedge ratio. d. Find the call option price. 

e. Explain what is meant by arbitrage and examine its implications in the evaluation. 

f. Examine how the "no-arbitrage" argument is used in your binomial valuation.

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In the tree diagram S represents the initial share price 110 u represents the price increase factor 110 and d represents the price decrease factor 095 ... View the full answer