It is argued that arbitrage can be a powerful tool in determining the approximate cost of...

  

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It is argued that arbitrage can be a powerful tool in determining the approximate cost of an investment but it is more an exception than a rule that it will result in a unique cost. Substantiate this statement by considering the following example for a simple one-period option pricing model and show that if there are more than two possible next-period security prices, then there will be no unique no-arbitrage cost for this option but rather there will be a range of the values for this option: Consider a call option for a security whose initial price of the security is R400 and suppose that the price at time-1 can be any of the values R350, R475 or R500. The strike price is R450. [Please note, this question is different than the one asked in the test so do not copy-paste the same answer.] [6] It is argued that arbitrage can be a powerful tool in determining the approximate cost of an investment but it is more an exception than a rule that it will result in a unique cost. Substantiate this statement by considering the following example for a simple one-period option pricing model and show that if there are more than two possible next-period security prices, then there will be no unique no-arbitrage cost for this option but rather there will be a range of the values for this option: Consider a call option for a security whose initial price of the security is R400 and suppose that the price at time-1 can be any of the values R350, R475 or R500. The strike price is R450. [Please note, this question is different than the one asked in the test so do not copy-paste the same answer.] [6]

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Consider a call option for a security with the following parameters Initial price of the security S ... View the full answer