{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

ps5solutions

# ps5solutions - BAYLOR UNIVERSITY HANKAMER SCHOOL OF...

This preview shows pages 1–2. Sign up to view the full content.

1 B AYLOR U NIVERSITY H ANKAMER S CHOOL OF B USINESS D EPARTMENT OF F INANCE , I NSURANCE & R EAL E STATE Dr. Garven Name __SOLUTIONS___ Problem Set #5 (extra credit) 1. The price of a share of ABC stock is currently \$50. It is known that at the end of 1 year, the ABC share price will be either \$100 or \$25. The riskless interest rate is 4% per year. Using the delta hedging, risk neutral valuation, and replicating portfolio approaches, calculate the price of a European call option on ABC stock with an exercise price of \$40 that expires 1 year from today. Delta Hedging Approach : At the end of 1 year, the value of the call option will be either \$60 (if the stock price is \$100) or \$0 (if the stock price is \$25). Consider a portfolio consisting of shares and -1 call option. Then the value of the portfolio will be either 25 or 100 - 60 in 1 year. If we select such that the portfolio is perfectly hedged, then 25 = 100 - 60, = 0.80, and the value of the portfolio will be \$20 with complete certainty. The current value of the riskless hedge portfolio is 0.80 x \$50 c , where c represents the value of the call option. Since the portfolio must earn the riskless rate of interest, we can solve for c by determining the future value of 0.80 x \$50 c and equating this with the \$20 certain future value of our portfolio: (0.80 x \$50 c ) e . .04 = \$20 \$40 - \$20 e -.04 = c c = \$40 \$19.22 = \$20.78 Consequently, the value of this call option is \$20.78.

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern