Consider a stock currently trading at 25 that can go up or down by 15 percent per period. The risk-free rate is 10 percent. Use one-period binomial model.
a. Determine the two possible stock prices for the next period.
b. Determine the intrinsic values at expiration of a European call with an exercise price of 25.
c. Find the value of the option today.
d. Construct a hedge by combining a position in stock with a position in the call. Calculate the hedge ratio and show that the return on the hedge portfolio is the risk-free rate regardless of the outcome, assuming that the call trading at the price obtained in part c.
e. Determine the rate of return from a risk-free hedge if the call is trading at 3.50 when the hedge is initiated.