FBE559.slides.07

The options value next period is either 34075 or 0

Info iconThis preview shows page 1. Sign up to view the full content.

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

Unformatted text preview: flows. Example (continued) Step 1 (continued): 2 Suppose the stock price goes down to $25 in period 1. Repeat the above for node (t = 1, down): The replicating portfolio is a=0 and b = 0. The call value at the lower node next period is Cd = 0. Example (continued) Step 2: Now go back one period, to Period 0. The option’s value next period is either 34.075 or 0 depending upon whether the stock price goes up or down: C0 Cu = 34.075 Cd = 0 If we can construct a portfolio of the stock and bond to “replicate” the value of the option next period, then the cost of this “replicating portfolio” must equal the option’s present value. Find a and b so that 75a + 1.1b = 34.075 25a + 1.1b = 0. The unique solution is a = 0.6815 and b = −15.48. Step 2: (continued) The cost of this portfolio is (0.6815)(50) − 15.48 = 18.59. The present value of the option must be C0 = 18.59 (which is greater than the exercise value 0). Note: this also confirms that the option will not be exercised before maturity. Summary of the replic...
View Full Document

This document was uploaded on 10/28/2013.

Ask a homework question - tutors are online