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