7.

(a)
When the price go up it will be 110 dollars. If the price go down after the next period then it
will be 90 dollars.
At the end of two months the value of the option will be either 10 dollar (if the stock price is
110 dollar) or 0 dollar (if the stock price is 90 dollar). Consider a portfolio consisting of:
shares
1 option
The value of the portfolio is either 90 or 110 10 in the next period. If
90 = 110 10
This gives;
= 0.5
If the stock price moves up to 110 dollar, the value of the portfolio is
110 x 0.5 10 = 45
If the stock price moves down to 90 dollar, the value of the portfolio is
90 x 0.5 = 45
The riskfree rate is 5% for this period. It follows that the value of the portfolio today must be
the present value of 45, or
45exp-(0.05 x 1) = 42.805
The value of the stock price today is known to be 100 dollar and the option price is denoted
by f. The value of the portfolio today is
100 x 0.5 f = 50 f
It follows that
50 f = 42.805
or
f = 7.195
The value of the option is therefore 7.19 dollar.
Whats still missing is the hedge ratio..
(b)
This can also be calculated using risk-neutral valuation. Suppose that p is the probability of
an upward stock price movement in a risk-neutral world. We must have
110p + 90(1p) = 100 exp(0.05 x 1)
This gives;
20p = 15.13
or:
p = 0.7565
The expected value of the option in a risk-neutral world is:
10 x 0.7565 + 0 x 0.2435 = 7.565

This has a present value of

7.565 exp-(0.05 x 1) = 7.196 dollar
Hence the above answer is consistent with risk-neutral valuation.
(c)
At the end of two months the value of the option will be either 10 dollar (if the stock price is
90 dollar) or 0 dollar (if the stock price is 110 dollar).
When calculating the value of the put using risk-neutral valuation, we have again p which is
the probability of an upward stock price movement in a risk-neutral world. We must have
110p + 90(1p) = 100 exp(0.05 x 1)
This gives;
20p = 15.13
or:
p = 0.7565
The expected value of the option in a risk-neutral world is:
0 x 0.7565 + 10 x 0.2435 = 2.435
This has a present value of
2.435 exp-(0.05 x 1) = 2.316 dollar
(d)
Now with put-call parity