This question is designed to demonstrate the practical application of option-based hedging: a. What is the principle underlying the call option pricing model? b. Using the data from question 2, how many options should an investor hold in a portfolio, including the underlying share, to construct a risk-free portfolio?
c. Using the data from question 1, how many options should an investor hold at the start of the first period in order to build a risk-free portfolio for the end of the first period? How many options should an investor hold at the start of the second period in order to build a risk-free portfolio for the end of the second period? Demonstrate that the portfolio is indeed risk-free at each stage. d. What can you conclude about option-based hedging according to the Black-Scholes formula in part (a) above?
