The following is a Binomial Option Pricing Model question. There will be 7 questions asked about it. Since the order of questions chosen is random, I suggest you solve the following all at once and choose your answer to each part as it comes up.

You will be asked the following questions:

1. What are the values of the calls at maturity, t=2?

2. What are the values of the calls at t =1?

3. What is the initial (t = 0) fair market price of the call?

4. What is the initial (t = 0) hedge ratio?

5. What are the hedge ratios at t = 1?

6. If one call was written initially, what is the value of the hedged portfolio one period later (t = 1)?

7. If the stock moves down in period 1 how would you adjust your t = 0 hedge by trading only stock?

We have a 2-state, 2-period world (i.e. t = 0, 1, 2). The current stock price is 100 and the risk-free rate each period is 5%. Each period the stock can either go up by 10% or down by 10%. A European call option on this stock with an exercise price of 90 expires at the end of the second period.

If the stock moves down in period 1, how would you adjust your t = 0 hedge by trading only stock? (closest answer)

		sell about 0.39 shares of stock
		buy about 0.09 shares of stock
		sell about 0.09 shares of stock
		buy about 0.39 shares of stock