Question: We obtained the binomial option pricing formula by hedging a short position in the call option with a long position in stock. An alternative way

We obtained the binomial option pricing formula by hedging a short position in the call option with a long position in stock. An alternative way to do this is to combine the stock and a risk-free bond to replicate the call option. Construct a one-period binomial option pricing model in which the stock and a risk-free bond are used to replicate a European call option. Then show that the option pricing formula is the same as the one developed in the text. Hint: Hold ns shares of stock and issue B dollars of bonds paying r percent so that the value in both outcomes matches precisely the value of the option. Then solve for ns and B and substitute back into the formula for the value of the hedge today to obtain the formula for C?

Step by Step Solution

★★★★★

3.44 Rating (186 Votes )

There are 3 Steps involved in it

1 Expert Approved Answer

Step: 1 Unlock

Let B be the amount issued in bonds Then the initial ... View full answer

Question Has Been Solved by an Expert!

Get step-by-step solutions from verified subject matter experts

Step: 2 Unlock

Step: 3 Unlock

Document Format (1 attachment)

768-B-F-F-M (7076).docx

120 KBs Word File

Students Have Also Explored These Related Finance Questions!

QBV, a non-dividend-paying stock, is currently trading for $80 a share. There is a 25-percent chance that the stock will trade for $65 in one year, and a 75-percent chance that the price will...

Shorewood Systems stock currently sells for $50 per share. One year from today the stock will be worth either $58.09 or $43.04.The continuously compounded risk-free rate is 5.13% for one year. Based...

Hopkins Pharmaceuticals stock is currently priced at $40 per share. Six months from now its price will be either $44.21 or $36.19. If the price rises to $44.21, then six months later the price will...

6. (Concept Problem) In this chapter, we obtained the binomial option pricing for- mula by hedging a short position in the call option with a long position in stock. An alternative way to do this is...

Kindly help with these finance questions. Please see attached document below for the questions and solution templates. PROBLEM 8-9 Given Beta Dividend payout ratio EPS for 2007 Stock Price (12/07/06)...

The goal of this project is to explore the topic of financial options. The project requires you to work in Excel with the provided spreadsheet. Be sure to fill in the yellow boxes in the Excel file...

Your Aunt Betty has a $120,000 investment portfolio comprising some Government of Canada three-month Treasury Bills and 2,000 Suncor shares. When the portfolio was formed (one month ago), the shares...

2 2 . You have a long position in a stock and a short position in a call option on the stock. The current price of the stock is $ 2 0 . In 3 months, it will either be $ 2 4 or $ 1 6 . The 3 - month...

I need a step by step solutions for the 10 problems in the excel file. The correct answers are provided I only need the solutions steps. Subject is Finance (options valuation) On March 2, a Treasury...

a. Construct a model for CH, (methane) by adding a ball representing hydrogen to each of the four bonds of your carbon model. Draw the full structural formula represented by this model. b. Remove one...

Unilever Group is a global company that markets a wide variety of products, including Lever® soap, Breyers® ice cream, and Hellmans® mayonnaise. A recent income statement and statement of...

Which statement does NOT reflect a potential planning fallacy? Select an answer: Let's go with our best - case scenario. They took longer because they didn't know what we know. Let's find statistics...

True or False: For any event A, we have P(not A) = 1 P(A)?

Project S has a cost of $10,000 and is expected to produce benefits (cash flows) of $3,000 per year for 5 years. Project L costs $25,000 and is expected to produce cash flows of $7,400 per year for 5...

Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are shown below: The projects are equally risky, and their cost of capital is 12 percent. You must...

After discovering a new gold vein in the Colorado Mountains CTC Mining Corporation must decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction,...

Sample run 1 Enter text: The two kids played and played, and finally got tired, and fall asleep a : 8 b : 0 c : 0 d : 7 e : 6 f : 2 g : 1 h : 1 i : 3 j : 0 k : 1 1 , : m m , 0 n : 4 @: 2 p : 3 q : 0...

Question 1(1 point) Given the nature of both tools, the solution selection matrix is a more complex tool to select solutions compared to the impact/effort matrix. Question 1 options: TrueFalse...

how do i answer The Journal of Travel conducted research by taking two large groups (viewed as populations) to determine whether there are differences in the characteristics of the two groups of...