Two-State Option Pricing Model Ken is interested in buying a European call option written on South-eastern Airlines, Inc., a non-dividend-paying common stock, with a strike price of $60 and one year until expiration. Currently, the company’s stock sells for $62 per share. Ken knows that, in one year, the company’s stock will be trading at either $73 per share or $49 per share. Ken is able to borrow and lend at the risk-free EAR of 2.5 percent.

a. What should the call option sell for today?

b. If no options currently trade on the stock, is there a way to create a synthetic call option with identical payoffs to the call option just described? If there is, how would you do it?

c. How much does the synthetic call option cost? Is this greater than, less than, or equal to what the actual call option costs? Does this make sense?

Answer rating: 100% (QA)

a000 We know the stock will be worth 73 or 49 in one year We also know the riskfree interest rate is 25 This is a twostate option pricing model We can use the following formula to calculate the value ... View the full answer