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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

BINOMIAL MODEL The current price of a stock is $55. In 1 year, the price will be either $50 or $65. The annual risk-free rate is 5.5%. The stock has an exercise price of $60 and expires in 1 year.

  1. a. Find the range of values for the ending stock price and the call option at the option's expiration in 1 year.
  2. b. Equalize the range of payoffs for the stock and the option.
  3. c. Create a riskless hedged investment. What is the value of the portfolio in 1 year?
  4. d. What is the cost of the stock in the riskless portfolio?
  5. e. What is the present value of the riskless portfolio?
  6. f. From your answers in parts d and e, what is the value of the firm's call option?

a.

Summary Introduction

To determine: The range of values for the ending price of stock and call option.

Introduction:

A type of security in a company that denotes ownership is termed as stock. Every company can raise capital funds by issuing stocks.

Explanation

Given information:

The annual risk-free rate of s stock is 5.5% and present stock price is $55. The price might be $50 or $65 in one year. The stock has an exercise price of $60 and time until expiration is 1 year.

The formula to compute the range is as follows:

Range=Ending PriceExercise price

Compute the range of values for the ending price of stock and call option:

The table below shows the Excel formula to calculate the range of values for the ending price of stock and call option:

b.

Summary Introduction

To determine: The range of payoff for option and stock.

Introduction:

Option is a contract to purchase a financial asset from one party and sell it to another party on an agreed price for a future date.

c.

Summary Introduction

To determine: The value of portfolio in one year by creating a riskless hedged investment.

Introduction:

A set of financial investments owned by the investor is termed as Portfolio.

d.

Summary Introduction

To determine: The cost of the stock in the riskless portfolio.

e.

Summary Introduction

To determine: The present value of riskless portfolio.

f.

Summary Introduction

To determine: The value of call option of the firm.

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