1
- Given your forecast of _____ you know what the option is worth at expiration.
- The question is establishing what the contract should sell for today (C0).
future ET share prices,
2
Three steps to follow:
1. design a hedge portfolio consisting of one share of ET held long and some number of call options (h),
2. assumes capital market that are free from arbitrage
3. establishing the call’s fair market value.
3
- _____), so that the combined position will be riskless
- The number of call options needed can be established by ensuring that the portfolio has the same value at expiration date no matter which of the two forecasted share prices occur,
design a hedge portfolio consisting of one share of ET held long and some number of call options (h
4
- so that all riskless investments are priced to earn the risk-free rate overtime until expiration.
- The hedge portfolio costing (50 - (2)(C0)] today would grow to the certain value of 40 pesos by the following expression:
assumes capital market that are free from arbitrage,
5
- That is, 6.48 represents the fundamental value of one-year call option on ET shares, given both the prevailing market prices for two other securities (shares and t-notes) and the investors forecast of future share values,
- which becames critical element in determing of the present value is reasonable estimate.
- Because the call option is currently out of the money. This amount is purely time premium.
establishing the call’s fair market value.