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This problem set is to be turned in by Wednesday, April 7th 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF.
Solution: The option payoff is fu = 0 and fd = 2.5. Next, let x denote the number of shares and y
dollar amount of bond in the replicating portfolio. Then x and y should satisfy
27.5x + y = 0
22.5x + y = 2.5
x = 0.5, y = 13.75.
(c) In the real world, risk-averse investors require the return on the stock to be 7%. What is the probability
p of upward movement in the real world?
(d) What is the appropriate discount rate for the option in the real world? Does the obtained discount rate
make sense?
Solution: Let rp denote the discount rate for this put option. Then,
rp = 52.2%. Considering the CAPM, the negative expected return is possible for an asset having a
large negative systematic risk. A put option is one of such examples, because put option pays off exactly
when the underlying stock performs badly.
e0.043/12 0.93
p= = 0.572.
1.07 0.93
The option payoff at maturity is fuu = 5.796, fud = 0, and fdd = 0. Then, the option price is
e0.04/2 0.92
p= = 0.626.
1.08 0.92
Thus, p = 0.820.
The stock prices at maturity are Suu = 34.99, Sud = 29.81, and Sdd = 25.39. Thus, for the option to be
exercised, the stock price has to increase twice. This probability is the risk-neutral world is p2 = 0.392, and
the probability in the real world is (p )2 = 0.673. The probability that the call option is exercised is higher
in the real world.