By law of one price this must be premium of the oprtfolio

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Reference no: EM131003071

Consider a risk free asset that can be bought (lent) or sold (borrowed) with an interest rate of 75% such that $1 today is worth$1.75 a period later |

Assemble a portfolio of X shares of stock and Y dollars of the risk free asset (quantities may be negative) to replicate the payoff from the option

WhenS1=$200: X*$200 + Y*$1.75 = $75 WhenS1=$50: X*$50 + Y*$1.75 = $0

Two equations in two unknowns

X * $50 + Y * $1.75 = $0

X = -1.75/50 Y = -0.035 Y

X*$200 + Y*$1.75 = $75 200 * -0.035 Y + Y * 1.75 = $75 -5.25 Y = 75

Y = 75/-5.25 = -14.29 (rounded )

1a. What is the number of shares (X) to be held in addition to the -$14.29 in the replicating portfolio?

1b. Demonstrate that this portfolio (X shares and Y cash) replicates the payouts of the option in both boom and bust.1c3. What is the price at time 0 of the replicating portfolio? By the Law of One Price this must be the premium of the option?

Reference no: EM131003071

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