Optimal strategy assuming that he purchases the contract

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Reference no: EM132206633

Suppose an investor has the opportunity to buy the following contract, a call option, on March 1. The contract allows him to buy 100 shares of ABC stock at the end of March, April or May at a guaranteed price of $50 per share. He can exercise this option at most once. For example, if he purchases the stock at the end of March, he can't purchase more in April or May at the guaranteed price. The current price of the stock is $50. Each month, assume that the stock price either goes up by a dollar (with probability 0.55) or down by a dollar (with probability 0.45). If the investor buys the contract, he is hoping the stock price will go up. The reasoning is that if he buys the contract and the stock goes up to $51, he can exercise the option and buy the stock for $50 and re-sell it immediately for $51 and make a prot of $1 per share. On the other hand, if the stock price goes down, he doesn't have to exercise the option; he can just throw the contract away.

(a) Use a decision tree to nd the investor's optimal strategy assuming that he purchases the contract.

Reference no: EM132206633

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