Reference no: EM132734434

Problem - Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid-sized California company that specializes in creating high-fashion clothing. Because no one at Triple Play is familiar with the basics of financial options, you have been asked to prepare a brief report that the firm's executives can use to gain a cursory understanding of the topic.

To begin, you gathered some outside materials on the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the report is to use a question and-answer format. Now that the questions have been drafted, you have to develop the answers.

Consider a stock with a current price of P = $27. Suppose that over the next 6 months the stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call option on the stock with a strike price of $25 that expires in 6 months. The risk-free rate is 6%.

Required -

(1) Using the binomial model, what are the ending values of the stock price? What are the payoffs of the call option?

(2) Suppose you write one call option and buy Ns shares of stock. How many shares must you buy to create a portfolio with a riskless payoff (i.e., a hedge portfolio)? What is the payoff of the portfolio?

(3) What is the present value of the hedge portfolio? What is the value of the call option?

(4) What is a replicating portfolio? What is arbitrage?