Question 1: One-period binomial model and arbitrage (Total 17 marks)

Consider a stock worth $128 that can increase by 15 percent or decrease by 10 percent per period. The risk-free rate is 6 percent. Use a one-period binomial model:

Required:

i. Follow the five steps outlined in Lecture 4 on Option Pricing - Binomial Model to determine the value of a European call option with an exercise price of $120. Note that marks will be deducted for not following the prescribed steps or for using notations or formulas not covered in this topic. (7 marks)

ii. Construct a hedge by combining a position in the stock with a position in the call option. Demonstrate that the return on the hedge equals the risk-free rate, regardless of the stock's outcome, assuming the call option is priced at the value you calculated. (5 marks)

iii. Suppose the call option is currently trading at $14.5. Calculate the amount of riskless return that can be earned using a riskless hedge. Draw a conclusion about the chosen strategy. Assume short-selling is allowed and that you can borrow and lend at the risk-free rate. (5 marks)

Question 2:Optionstrategies(Total 14 marks)

This question has two Parts. Answer Parts (a) and (b) below

Part (a) - 5 Marks

Briefly explain and compare two option trading strategies: covered call and protective put. When should an investor enter each strategy?