Stock XYZ trades for $100 and pays no dividends. Next year, with probability 95% it will...

 

Transcribed Image Text:

Stock XYZ trades for $100 and pays no dividends. Next year, with probability 95% it will be worth $110, and with probability 5% it will fall to $70. The interest rate is 5% with annual compounding. Consider a 1-year European call option on XYZ with strike price $90. a. What is the no-arbitrage price of the call? b. You form a portfolio of XYZ and the risk-free asset that has the same expected return as the call in (a). What must be your portfolio weight on stock XYZ? (Remark: the right answer shows how options give you leverage). Stock XYZ trades for $100 and pays no dividends. Next year, with probability 95% it will be worth $110, and with probability 5% it will fall to $70. The interest rate is 5% with annual compounding. Consider a 1-year European call option on XYZ with strike price $90. a. What is the no-arbitrage price of the call? b. You form a portfolio of XYZ and the risk-free asset that has the same expected return as the call in (a). What must be your portfolio weight on stock XYZ? (Remark: the right answer shows how options give you leverage).

Answer rating: 100% (QA)

a To calculate the noarbitrage price of the 1year European call option on stock XYZ with a strike price of 90 we can use the riskneutral probability a... View the full answer