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A 6 month European call option on a share in ABC Ltd has an exercise price of $20. The current share price for ABC Ltd is $18.50. After 6 months, the share price will either rise to $22 or fall to $14. Assume that j1 = 5% p.a.
Consider a strategy today where you buy h shares of ABC Ltd and borrow B dollars. Showing your working, find the values of h and B that will replicate the payoff from the 6 month European call option on ABC Ltd shares described above regardless of whether the share price rises or falls. Express h as a fraction and quote B rounded to 5 decimal places. Illustrate this model in a carefully labelled contingent cash flow diagram.
Using your result from part (a), calculate the no-arbitrage option price. Give your answer in dollars rounded to two decimal places.
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