Question

1) We discussed calls in class. A call is a financial instrument that allows the owner of the call to buy a stock at a certain price. ie., if google is selling for $100/share. And I own a call for $105. That means i have the right to buy google at $105 from the institution that sold me the call. Today, I would not use my right to buy at $105, because it would be cheaper to simply by Google at $100 (the current market price). However if the market price of google goes to $110, i could, and probably would use my right to buy at 105, sell at 110 and pocket the difference. This type of instrument is called an 'option' as I, the owner, have the option to use or not use my right of ownership. Based on the price. Lets use the simple risk model we discussed in class. Ie, there is a 50/50 chance of one of two outcomes happening. Specifically, there is a 50% chance Google will go to $110, and a 50% chance it will go to $90. a) How much would you expect the call option to sell for?

Answer 1

Assuming risk free rate to be zero:

Price of call option=(0.5*max(110-105,0)+0.5*max(90-105,0))=2.5

Hence, call option should sell for $2.5