Term
| Describe the replicating portfolio: |
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Definition
| is a concept that holds that the outlay for a bankruptcy free stock position should be the same as the outlay for a long call position with the same payoff. |
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Term
| Using the hedge ratio to develop the replicating portfolio: |
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Definition
HR = (cU - cD) / (SU - SD)
e.g., (75-0) / (200 - 150) = 0.5
This tells us that one option contract is needed for each half share of stock |
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Term
Synthetic call replication. Describe how you can calculate the call price using the HR, stock price, and PV of the borrowings...
What is this also known as: |
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Definition
call price = hedge ratio * (stock price - PV(borrowings))
the option delta |
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Term
| Risk-neutral valuation. How do you calculate the up movement and down movement: |
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Definition
U = eσ√t
D = eσ√t = 1 / eσ√t = 1/U |
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Term
| Risk-neutral probabilities. How do you calculate the risk-neutral probabilities of upward and downward movements? |
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Definition
probability of an up move = (ert - D) / (U - D)
probability of a down move = 1 - (probability of an up move) |
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