Risk Neutral Valuation of a Derivative
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A stock is currently $25. It is known that at the end of 2 months it will be either $23 or $27. The risk-free interest rate is 10% per annum with continuous compounding. What is the value of a 2-month derivative that will be either 529 (if the stock price is 23) or 729 (if the stock price is 27)? Use no-arbitrage arguments. Consider a portfolio of:
+delta : shares
-1: derivative
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Solution Summary
The solution values a derivative using Risk Neutral Valuation.
Solution Preview
See the attached Excel file for a proper presentation of this solution.
Portfolio has
+delta : shares
-1: derivative
Therefore
At time t=0
Value of portfolio at time t=0 is $25 delta -f
where f is the value of derivative
At time ...
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