lec04_02 - ECON 4721H Money and Banking Lecture 04_02...

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Unformatted text preview: ECON 4721H Money and Banking Lecture 04_02 Satoshi Tanaka University of Minnesota October 12, 2011 Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Financial Derivatives II Pricing Options Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Today's Question How is the price of an option determined? How can we approximate option's payo by a portfolio of a stock and a risk-free rate? Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Option Pricing Strategy 1 We create a portfolio of a stock and a risk-free asset which give the same payo as the option. 2 If the market works e ciently, and if the Law of One Price holds, the portfolio and the option should have the same price! Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Simple Case: Binomial Pricing We will price a European call option! Time periods: 0, 1 Initial stock price: S Stock price in period 1: ( 1 + u ) S , or ( 1 + d ) S Risk-free rate: ( 1 + r f ) Assumption: u > r f > d Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Movement of Stock Price S (1 + u ) S (1 + d ) S Satoshi Tanaka ECON 4721H Money and Banking Lecture 04_02 Payo s of Call Option...
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This note was uploaded on 02/07/2012 for the course ECON 4721H taught by Professor Tanaka during the Fall '11 term at Minnesota.

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lec04_02 - ECON 4721H Money and Banking Lecture 04_02...

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