FBE559.slides.07

The solution has subtracting the rst equation from

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: ion has (subtracting the first equation from the second): 25 = 100x ⇒ x = 1 Substituting in, we also get y = − 8 1 4 Binomial Stock Example I (continued) So we see we have the replicating portfolio: 1 4 150 × 50 - 1 8 × 100 100 = So we must have C0 = Jump to Method #2 1 1 × 100 − × 95 = $13.125 4 8 Jump to Method #3 25 0 Expressing the Time-value of Money We could state the discount rate in a few ways: 1 90 2 100 100 The annualized interest rate (with no compounding) is 11.11% 100 111.10 111.10 The price of a 1-year zero coupon bond with face value $1 is 1/1.111 = 0.90 3 The continuously compounded rate is − log(.9) = 10.54%, so that the price of a 1-year zero coupon bond is e −.1054 = 0.90. Hull uses the last method. For now, all we need is the price of the zero coupon bond, so I use the first method. One-period Binomial Model Assumptions: Binomial price movement Frictionless market (no cost for buying or selling) Bd < 1 < Bu (Why do we need this?) Notation: S0 : initial stock price S0 u : stock price if it goes up S0 d : stock price if it goes down B : present value of $1 in the future If you don’t like B , use 1 1+r instead Basic Idea of Pricing: find a replicating portfolio, and use the no arbitrage argument Option Delta Definition Number of shares needed to replicate one call option is called hedge ratio or option del...
View Full Document

This document was uploaded on 10/28/2013.

Ask a homework question - tutors are online