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Unformatted text preview: example:
Stock
u = 1.25 Option (X = $35)
$50 $40 C
d = 0.75 $30
H = 0.75 Cu = Su – X = $50 $35 = $15 Cd = 0 not exercised) Option Pricing
Option Pricing Binomial Option Pricing Model
Qn: Then what is the price of the call (C)?
Basic principle: The return on a Hedged portfolio
= Riskless rate (r) At the end of 1 period, initial investment will become: = (HS – C) (1 + r) Option Pricing
Option Pricing Binomial Option Pricing Model
Since payoffs are the same regardless of price. (HS – C) (1 + r) = uHS – Cu or dHS Cd Substituting for H:
C = [(1+rd)/(ud)][Cu/(1+r)] + [(u1r)/(ud)][Cd/(1+r)] = $9.17 (in the example if r = 8%) Option Pricing
Option Pricing Binomial Option Pricing Model
2 Period Model
Stock Option (X = $35)
Cuu = $50 $35 $50
Cu $44.72
$38.73 $40
$34.64 Cud = Cdu = $38.73 $35 = $3.73 C $30 u = 1.118, d = 0.866 = $15 Cd Cdd = 0 Option Pricing
Option Pricing Binomial Option Pricing Model
Cu = [(1+rd)/(ud)][Cuu/(1+r)] + [(u1r)/(ud)][Cud/(1+r)] = $11.04 Cd = [(1+rd)/(ud)][Cdu/(1+r)] + [(u1r)/(u...
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This document was uploaded on 04/02/2014.
 Spring '14

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