Consider a one period two-state case in which XYZ stock is trading at S0= $35 and has ?u of 1.05 and d ?of 1/1.05, and for which the period risk free rate is 2%.
a. Using the BOPM, deterine the equilibrium price of an XYZ 35 European call option expiring at the end of the period.
b. Explain what an arbitrageur would do if the XYZ European call option was priced at $1.35. Show what the arbitrageur's cash flow would be when he closed.
c. Explain what an arbitrageur would do if the XYZ 35 European call was priced at $1.10. Show what the arbitrageur's cash flow would be at expiration when he closed.