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    Replication and Risk-Neutral Method: Value of a Call Option

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    Burgundy Corporations stock price is currently $100. At the end of 3 months it will be either $110 or $90.91. The risk-free interest rate is 2% per annum. What is the value of a 3-month European call option with a strike price of $100? Calculate your answer to this problem using

    (a) replication.

    (b) the risk-neutral method.

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    Solution Preview


    First we need to calculate the option's hedge ratio:

    ∆ = (10-0) / (110-90.01) = 0.5238

    In order to to replicate the call, we need to buy ∆ shares and finance this by borrowing at rf . Assuming the given rate is the APR, the amount ...

    Solution Summary

    Using both replication and the risk-neutral method, the value of a 3 month call option is found for the Burgundy Corporations example.