
The current price of Estelle Corporation stock is $25. In each of the next two years, this stock price will either go up by 20% or go down by 20%. The stock pays no dividends. The one-year risk-free interest rate is 6% and will remain constant. Using the Binomial Model, calculate the price of a one-year call option on Estelle stock with a strike price of $25.

To determine: The price of a one year call option on ET stock.
Introduction: A binomial model portrays the development of irregular variables over a progression of time steps, relegating specified probabilities to increase or decrease in the variable. The binomial option pricing model makes the improving supposition that, toward the finish of every period, the price of stocks has just two conceivable values.
Answer to Problem 1P
Explanation of Solution
Determine the increase or decrease in the stock price.
Therefore, the stock price either increases to $30 or decreases to $20
Here
S – Denotes the current stock price
K – Denotes the strike price
C – Denotes the call price
B – Denotes the risk-free investment or initial investment in the portfolio
Su – Denotes the probability of increase in stock price (the price to go up)
Sd – Denotes the probability of decrease in stock price next period (the price to go down)
rf – Denotes the risk-free rate
Cu – Denotes the price of the call option if the stock price increases (the price to go up)
Cd – Denotes the price of the call option if the stock price decreases (the price to go down)
Δ – Denotes the shares of stock in the portfolio or the sensitivity of option price to stock price
Determine the option payoff:
Using Excel function =MAX, the option payoff is determined as follows:
Excel spreadsheet:
Excel workings:
Therefore, the option payoff either increases to $5 or decreases to $0.
Determine the shares of stock in the replicating portfolio:
Therefore, the share of stock in the replicating portfolio is 0.5.
Determine the risk-free investment or initial investment in the portfolio:
Therefore, the risk-free investment or initial investment in the portfolio is -9.4340.
Determine the price of a one year call option on ET stock:
Therefore, the price of a one year call option on ET stock is $3.07.
Want to see more full solutions like this?
Chapter 21 Solutions
Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
Additional Business Textbook Solutions
Financial Accounting: Tools for Business Decision Making, 8th Edition
Engineering Economy (17th Edition)
Gitman: Principl Manageri Finance_15 (15th Edition) (What's New in Finance)
Horngren's Cost Accounting: A Managerial Emphasis (16th Edition)
Horngren's Financial & Managerial Accounting, The Financial Chapters (Book & Access Card)
Horngren's Accounting (12th Edition)
- Company A has a capital structure of $80M debt and $20M equity. This year, the company reported a net income of $17M. What is Company A's return on equity?* 117.6% 21.3% 85.0% 28.3%arrow_forward12. Which of the following is the formula to calculate cost of capital?* Total assets/Net debt x Cost of debt + Total assets/Equity x Cost of equity Net debt/Equity x Cost of debt + Equity/Net debt x Cost of equity Net debt x Cost of debt + Equity x Cost of equity Net debt/Total assets x Cost of debt + Equity/Total assets x Cost of equity .arrow_forwardno ai .What is the enterprise value of a business?* The market value of equity of the business The book value of equity of the business The entire value of the business without giving consideration to its capital structure The entire value of the business considering its capital structurearrow_forward
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT
