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Option B Pricing and Replication Strategy

The document outlines a financial problem involving options and a replicating portfolio. It provides the calculations for pricing option B, which is determined to be 0.4792, along with the composition of the replicating portfolio consisting of 1 stock, -1/3 bond, and -1.5 option A. The risk-free rate and possible future stock prices are also specified.

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75 views2 pages

Option B Pricing and Replication Strategy

The document outlines a financial problem involving options and a replicating portfolio. It provides the calculations for pricing option B, which is determined to be 0.4792, along with the composition of the replicating portfolio consisting of 1 stock, -1/3 bond, and -1.5 option A. The risk-free rate and possible future stock prices are also specified.

Uploaded by

aldiaryesirkep
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Problem 16 - Solution:

Given:

- Risk-free rate: r = 50%

- Current stock price: S0 = 1

- Possible future prices: Su = 2, Sm = 1, Sd = 0.5

- Option A pays $1 if S = 2, otherwise $0. Price of A: 0.125

- Option B pays $0.5 if S = 1, otherwise $0

- Portfolio to replicate B: x (stock), y (bonds), z (option A)

Scenarios:

State | Stock Price | A Payoff | B Payoff

--------|-------------|----------|---------

u |2 |1 |0

m |1 |0 | 0.5

d | 0.5 |0 |0

System of equations:

u: 2x + 1.5y + z = 0

m: x + 1.5y = 0.5

d: 0.5x + 1.5y = 0

Solve:

From (d): x = -3y

Substitute into (m): -3y + 1.5y = 0.5 => y = -1/3, x = 1

Substitute into (u): 2*1 + 1.5*(-1/3) + z = 0 => z = -1.5


Portfolio value today:

- x = 1, stock price = 1 => 1

- y = -1/3, bond = 1 => -1/3

- z = -1.5, option A = 0.125 => -0.1875

Total: 1 - 1/3 - 0.1875 = 0.4792

Answer:

- Price of option B: 0.4792

- Replicating portfolio:

x = 1 (stock)

y = -1/3 (bond)

z = -1.5 (option A)

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