Suppose the current price of a stock is $18. Consider a two state tree model defined...
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Suppose the current price of a stock is $18. Consider a two state tree model defined such that after 3 months, the stock price may increase to $19 with a 40% probability or decrease to $16 with a 60% probability. Consider a European call option, based on this stock, with strike price K=$17 and expiry time T = 3 months. Assume the riskfree interest rate is 9%. (a) (3 marks) Construct a riskfree portfolio and use it to determine the present noarbitrage value (fair value) of the option (i.e., at time t = 0). (b) (3 marks) Suppose such an option is priced on the market at V* = 2.0 (i.e., higher than the noarbitrage price). Describe the details for a strategy that will result in a guaranteed profit (in present value, i.e., at t = 0) and determine the value of that profit (per option), somewhat similar to what we did in class. (As usual in this course, we will assume short selling is allowed and the noarbitrage principle holds.) Suppose the current price of a stock is $18. Consider a two state tree model defined such that after 3 months, the stock price may increase to $19 with a 40% probability or decrease to $16 with a 60% probability. Consider a European call option, based on this stock, with strike price K=$17 and expiry time T = 3 months. Assume the riskfree interest rate is 9%. (a) (3 marks) Construct a riskfree portfolio and use it to determine the present noarbitrage value (fair value) of the option (i.e., at time t = 0). (b) (3 marks) Suppose such an option is priced on the market at V* = 2.0 (i.e., higher than the noarbitrage price). Describe the details for a strategy that will result in a guaranteed profit (in present value, i.e., at t = 0) and determine the value of that profit (per option), somewhat similar to what we did in class. (As usual in this course, we will assume short selling is allowed and the noarbitrage principle holds.)
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Answer rating: 100% (QA)
a To construct a riskfree portfolio we need to determine the number of shares of the stock and the investment in the riskfree asset such as a bond Let... View the full answer
Related Book For
Financial Management Theory and Practice
ISBN: 9780176517304
2nd Canadian edition
Authors: Eugene Brigham, Michael Ehrhardt, Jerome Gessaroli, Richard Nason
Posted Date:
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