Hedge portfolio earns the risk-free rate over both periods

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Consider a two-period, two-state world. Let the current stock price be 45 and the risk-free rate be 5 percent. Each period the stock price can go either up by 10 percent or down by 10 percent. A call option expiring at the end of the second period has an exercise price of 40.

Question:Construct an example showing that the hedge works. Make sure the example illustrates how the hedge portfolio earns the risk-free rate over both periods.

Reference no: EM131306596

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